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Are ETFs Overdone?

FYI | Jun 21 2017

By Peter Switzer, Switzer Super Report

I’m currently in Italy but last Thursday I rang into my radio program, which my colleague Paul Rickard was hosting. Thursday is usually called Radio Russian Roulette where anyone can ask any money question imaginable.

As I was in the rustic setting of Pozzo in Tuscany, it should have been called Radio Rustic Roulette, but that cleverness did come to me until I finished my hour. However, a caller did ask about our Switzer Dividend Growth Fund after his accountant raised issues around liquidity.

Undoubtedly, this concern came following an AFR story about ETFs [exchange-traded funds], and it follows a number of stories pedelled in the media. Before looking at the actual story that followed a warning from the RBA, let me point out that ETFs are taking business away from traditional fund managers and some journalists are being cultivated to make investors jumpy.

Also, while I live in awe of the great work of many accountants, I know they’re not, per se, experts on investments.

The AFR yarn started this way: The Reserve Bank of Australia has warned investors about the “liquidity risk” of the more complicated types of exchange traded funds (ETFs), which are increasingly being promoted by financial advisers.

The critical words to note are “more complicated” ETFs, and this warning is spot on. I’ve always been concerned that inexperienced investors would look at, say, an ETF based on the S&P/ASX 200 Index, which requires the fund to buy the 200 stocks in proportion to your investment.

If there was a GFC, and the over-arching company went broke, those shares bought in your name via the ETF would still be your assets. They might fall in value with a market crash, but you wouldn’t see your investment go to nothing.

On the other hand, more complicated or synthetic ETFs, which are linked to derivatives and other exotic products, could go to nothing in a crash, so investors have to know the difference between complicated and uncomplicated ETFs.

As the RBA and the AFR pointed out: While mum and dad investors are being encouraged to buy the ETFs through their self-managed super funds in order to diversify risk, in times of financial stress, it could be hard to sell some of the more thinly traded ETFs.

The SWTZ fund is an actively managed ETF, but it’s not complicated. We buy 30-40 dividend-paying stocks when someone invests with us, and if a crash happened and people wanted to get out, we’d have to sell the underlying stocks just like anyone else who was trying to dump stocks.

That said, when markets bottom, dividend-paying stocks are often the ones most sought after because of their reliable dividend streams, so the dumping factor might be more restrained and the bounce-back factor could be better than those stocks that derive their support from being good capital gainers.

At times I’ve wondered whether the growth of ETFs could lead to a more volatile market reaction when a stock market started to crash, as a sell order from one client would trigger 200 sales with an ETF linked to S&P/ASX 200 index. But in total, ETFs are only 1.5% of the ASX market capitalisation. In the USA, it is 10%.

I totally agree with this warning underlined in the AFR:

The RBA is also worried about some obscure ETFs, such as “inverse ETFs” which deliver returns that go in the opposite direction to the benchmark they are tracking or “leveraged ETFs” which are correlated to an index but much more volatile. “Some investors may not fully appreciate the risks of investing in these instruments.”

Interestingly, in 2006, Mark Cobley, writing in the Financial News, ran with a headline: Lack of liquidity causes ETF worries, but they were never fingered as a problem during the GFC and they have in fact grown in popularity since those very scary days for stocks.

The bottom line is, if you are in an ETF where the underlying assets are illiquid — that is, not easy to sell — then a crash could be a real concern. However, if the assets are easily sellable, such as stocks of the top 200 companies or the best dividend-payers in the land, then you might cop a capital loss with a crash, but you will get cash.

You can’t be so sure about exotic and synthetic ETFs.

Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.

Content included in this article is not by association the view of FNArena (see our disclaimer).

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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