"A lot of attention given to ETFs is overly simplistic or technical"
Mar. 14, 2011
Francis Groves is the author of the recently published book Exchange Traded Funds: A Concise Guide to ETFs. In this interview the ETF expert explains how to build a sensible portfolio from ETFs, the typical mistakes private investors make with ETFs, what they can do and simple steps to contain the biggest risks.
MyPrivateBanking: Francis, what was your motivation for writing the book?
Francis Groves: First of all, I’m a fan of ETFs - though with some reservations - and wanted to understand them better. Beyond that, a lot of the existing material about exchange traded funds is either US-focused or tied into specific investing strategies or both; there’s comparatively little written to open up ETFs to European private investors and financial advisers.
MyPrivateBanking: There is a lot of information on ETFs already out. On what aspects do you focus and what additional insights a reader can get from your book?
Francis Groves: Having said that I’m a fan of ETFs, although I believe they offer investors a number of great new opportunities, I wanted to balance that with some insight into areas where ETF investing becomes tricky. At the same time, I feel that a lot of the attention given to ETFs is either overly simplistic or overly technical.
The essentials of investing with ETFs simply won’t fit into the space allowed for in, say, the personal finance pages of newspapers, so mainstream media tend not to be very strong at covering the basics of how ETFs work. Nevertheless, if one’s thinking of using ETFs, it’s worthwhile taking the trouble to understand them, and their workings are not so complicated, just not always exactly what one would expect.
So this guide is designed to bridge the gap between general media coverage of ETFs – much of it just recommendations for individual funds – and the huge amount of specialist ETF information, which, in any case, is often targeted towards institutional investors.
MyPrivateBanking: Say you have 500’000 Euros and you would like to build an equity portfolio of more or less mirroring the global stock market, how many ETFs would be necessary and which would be the most important building blocks?
Francis Groves: I have to say that I’d be wary of attempting to capture the entire equity universe with ETFs. Firstly, I believe that beyond the developed markets, there are real problems with indexes and their constituents; too many energy companies in the Russian indexes, too many financial stocks in the Chinese ones, for example. Secondly, trying to buy the global stock market is going to preclude an investor from looking into alternative weighting methodologies - equal weighting or fundamental weighting instead of market cap - or style indexes or themes like global water or good dividend histories.
The closest I would get to a full universe of stocks would be a cornerstone portfolio of developed market indexes. You can take your pick of weightings and strategies. If I was planning a cap weighted investment, I would probably start with a DJ STOXX 600 tracker - not a FTSE 100 tracker - and add an S&P 500 tracker, a Japan Topix tracker and ETFs for the main markets in Australia and Canada. But it’s worth remembering that a European investor can build a developed markets portfolio based on fundamental weightings - though I’m not aware of European-domiciled fundamentally weighted Japan ETF - or even implement their own strategy of developed small cap and large cap indexes.
That’s not to say that I don’t like emerging markets but I’d probably take a more piece-meal approach and be more likely to consider investing in traditional funds and investment trusts as well as ETFs.
MyPrivateBanking: Which are typical mistakes you see when private investors start investing in ETFs?
Francis Groves: Following on from what I’ve just said about building an ETF portfolio, I think there’s a real danger of becoming so focused on a comprehensive strategy that investors overlook the all-important step of understanding the indexes they choose to track. For example, an investor might jump to the conclusion that a FTSE China 25 ETF was the best solution to the China ‘space’ in their portfolio.
Basically, there seems no doubt that ETFs can be empowering for private investors and they can save a lot of money in the form of expenses and redemption fees. However, there’s no getting away from the fact that they’re taking on more responsibility than with a holding in a traditional open ended fund, where the fund manager is dealing with complications like asset liquidity or currency risk.
While on that subject, I think there’s a tendency to talk up the revolutionary aspect of ETFs too far. True, they really can be empowering for self-investing investors but a lot of investors may decide that, having checked them out, they’re happier to delegate the running of an ETF portfolio to their financial adviser.
Another potential risk for ETF investors is that, having started out with a few relatively straightforward ETFs and been pleased with the outcomes, they stray into other asset classes without realising that the ETF label covers a whole range of levels of risk and what you might term the intuitiveness of asset performance. So they could switch tracks into short or leveraged ETFs or exchange traded commodities without realising that they were crossing a line.
Finally, there’s the danger of moving into using index tracking ETFs but using them in too active a fashion. Changing one’s mind too often brings additional costs in the form of dealing fees and the effect of bid/offer spreads.
MyPrivateBanking: Would you recommend to avoid ETFs that are swap based as opposed to full replication ETFs, or do you see other, more important risks in some ETFs that should concern investors?
Francis Groves: I do have some reservations about swap-based replication but certainly not enough to stop me investing in that kind of ETF. And if the sponsor has measures in place, like db x-trackers, to eliminate exposure to the swap counterparty on daily basis, I’m even more reassured.
On the plus side, swap-based ETFs - and ones based on partial in-kind replication - do open up some emerging markets where full in-kind replication runs into problems with the liquidity of index constituents, local taxes or plain foreign investment restrictions. Also, they can be more efficient at tracking total return indexes.
However, if you’re making a deal, it’s always nicer to have some insight into what’s motivating the other party. And the problem with swap-based ETFs is that the incentive for the swap counterparty - or indeed the ETF sponsor itself if they’re the same organization - can be opaque. True, you know that the counterparty is paid a fee for providing the swap but take, for example, a swap counterparty that’s guaranteeing the return of a European index ETFand provides Japanese stocks as collateral AND guaranteeing the return of a Japanese ETF and provides European stocks as collateral for that. It looks as if they might be hedging their European and their Japanese stocks and being paid for it into the bargain.
I wouldn’t go so far as to say that I prefer swap-based ETFs to ones based on in-kind replication but there are aspects of the latter that should give pause for thought. Securities lending by sponsors, for instance, can have counterparty risk and can seem like a way for institutions to make the opposite bet on the market to your’s; how annoying is that?
One area where I am skeptical about swap-based ETFs is when the sponsor gives the impression that the method simply abolishes problems arising in illiquid underlying assets. True the swap method gets around the problem illiquidity presents for in-kind replication but you still have the problem of establishing a net asset value and pricing the ETF.
MyPrivateBanking: Do you foresee any innovations and developments in the ETF-Universe beneficial for private investors?
Francis Groves: Firstly, I expect the whole area of funds of exchange traded funds and portfolios recommended by financial advisers to become a more typical way for ordinary investors to encounter ETFs in addition to simply trading them through online brokers.
Secondly, we’re beginning to see moves into commission-free dealing in countries like Germany and the UK as well as the United States. Clearly, this is going to have a big effect in opening up ETFs to the pensions savings market, for example.
Thirdly, I’m expecting - and hoping - that online brokers and fund supermarkets will become more informative about which ETFs you can buy through them. At present, unless you open an account, this information is patchy.
I’m not quite so confident that we’ll see effective moves to make the whole subject of ETF expenses more transparent. Although the UK’s Financial Services Authority is beginning to express concern about investors’ understanding in relation to ETFs, European regulators don’t seem to be as effective at regulating product information as they are at regulating financial intermediaries. However, if investors could better understand not only the products but also the regulators’ thinking about the products, the standard of financial advice would probably improve as a consequence.
Francis studied at the London School of Economics. He has many years of experience in the field of online business information, having worked for Reuters, the Financial Times and LexisNexis. He is the author of 'Corporate Actions, A Concise Guide' (2008) and the recently published 'Exchange Traded Funds, A Concise Guide to ETFs'. He lives 35 miles from London and enjoys reading (history, current affairs and fiction) in his spare time. His favored holiday destination is the Hebrides.