Not long ago, ETFs were all about providing passive investing designed to achieve broad diversification at low cost. That remains a great idea for most investors. But the financial services industry is rarely satisfied with the status quo. That can be a great thing when it comes to innovation and more choice. Sometimes though, it is possible to have too much of a good thing.
The ETF landscape has grown increasingly crowded. There are more than 1,000 ETFs available in Canada alone, and that number keeps growing.
As Rudy Luukko reported earlier this month, more than 300 new ETFs were launched this year. It is not only the number of ETFs available, but the complexity of available products.
We have gone from passive index-tracking to smart beta, to inverse, leveraged and other sophisticated derivatives-based strategies. Interested in exploring a collection of meme stocks or speculating on a single stock through an ETF strategy? There are ETFs for those as well. The upside potential can be attractive, but because a lot of these strategies are underpinned by derivatives, the downside risk can also be amplified.
Uncomfortable client discussions
Many of these strategies may sound attractive, but the devil is in the details. For those who like the idea of using an ultra-leveraged ETF that tracks an index, here’s an example of the problem of daily resetting typically associated with this type of ETF.
|
Index Level |
Index performance | 2X leveraged ETF performance | 2X leveraged ETF price |
|
100 |
– | – | $100 |
| 90 | -10% | -20% |
$80 |
| 100 | 11.1% | 22.2% |
$97.76 |
Following two days during which the underlying index was flat, the 2X leveraged ETF’s tracking performance of the same index is behind by just over 2%. This is because the leveraged performance is reset each day for the product.
When a market fluctuates throughout the day but remains flat over longer periods of time, significant differences can occur between the performance of an index and an ETF that tracks that index. Over time, the possibility of deviating more significantly from the index or tracked investment can grow. This is referred to as tracking error.
Today’s sophisticated, often expensive ETFs tend to be suitable for more experienced investors with specific objectives or speculators. For most advisors, the old fashioned, plain vanilla ETF strategies continue to be relevant.
They offer broad diversification through the passive tracking of benchmarks. They offer low fees and transparency. And you are less likely to have to explain why performance has not panned out as expected.
Furthermore, a smaller group of traditional strategies are needed to deliver a complete portfolio strategy. This allows you to focus more on managing the client relationship, and stay abreast of changes in their circumstances that could affect long-term goals and risk tolerance.
While the investment community has been blessed with oodles of choice in the ETF space, that is a mixed blessing. It puts more burden on advisors to assess the suitability of a growing range of products. Careful due diligence is required to separate long-term strategies from those that are more flashy, but short-term or speculative in nature.
Barakat has spent more than 20 years in the investment industry working with advisors and private clients in Canada and overseas. He holds the chartered investment manager and FCSI designations, and an MBA from Queen’s University.