ETFs – Get the Most Out of Them without Taking All the Risks

Passive investing and Exchange Traded Funds (ETFs) are all the rage. Increasingly, investors have come to the conclusion that active investing rarely beats market performance. However, as always when new products are becoming popular very quickly risks and unwanted side-effects are increasing as well. For the private investor it becomes trickier to select the optimal funds for his or her needs.

In April 2010 European domiciled exchange traded funds had almost €200 bn under management. In the first four months of 2010 alone these funds received more than €14 bn in net new money. In Europe there are now 932 funds listed on the exchanges overtaking the USA with 839 listed exchange traded funds. 

Given the present "ETF-hype", some private investors fear that exchange traded funds might have their own “dirty little secrets” to make them more profitable for the issuer but also riskier for the investor. Consequently it becomes more important for the private investor to compare exchange traded funds and examine the small print more closely.

The sheer number of new funds implies that many exchange traded funds are covering the same index but also that a multitude of funds are now covering very narrow or exotic market segments, often resulting in high costs, illiquid markets and non-transparent investments. We have also found that funds missed their benchmark by a wider margin than in previous years. 

In general, exchange traded funds and similar passive products are a good tool to construct a passive, market-performing strategy. However, in our report on the investment proposals of the Top20 wealth managers worldwide less than one third included exchange traded funds in their proposal, with a total share of the assets in the portfolio on average below 10%. 

Other wealth managers want to generate fees based on passive strategies that are more lucrative than the low fund fees of many exchange traded funds. The term “active strategy with passive products”, e.g. sector rotation with ETF products, has become very fashionable. However, such strategies may have the same flaws as normal active investment strategies. 

In order to answer these concerns we’ve published this new guide for private investors and wealth managers that takes an in-depth look at the following major ETF risks:

• The tracking error – or how big is the risk of missing the benchmark?

• The default risk – or how big is the risk that a fund can default?
  

• The trading risk – or how big is the risk that you have to pay too large a spread?
  

• Exotic ETFs – or how big is the risk that the underlying index or strategy leads to disaster?
  

• A special case: currency ETFs – are they too risky for private investors?
  

Overall, this guide provides the private investor as well as the experienced wealth manager with valid guide lines to avoid many risks in the increasingly complex world of exchange traded funds and index investing.