The Risks of Exotic ETFs – Don’t Be Too Adventurous…

MyPrivateBanking analysts have received several inquiries from concerned private investors who are worried that ETFs could be riskier than the marketing materials of ETF sponsors admit. Given the present "ETF-hype", some investors fear that ETFs might have their own “dirty little secrets” to make them more profitable for the issuer but also riskier for the investor. In order to answer these questions we will publish a series of articles to take an in-depth look at the following major risks of ETFs:

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

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

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

4. The Risks of Exotic ETFs – or how big is the risk that the underlying index or strategy could lead to disaster?
   

The following analysis addresses the risk of investing in exotic ETFs or, in other words, the danger that an investor invests in an unfamiliar underlying index of assets without appreciating or quantifying the risks. And the scope for branching out into exotic ETFs is increasing: last year Wall Street created 139 new exchange traded funds but, according to the Investment Fraud Blog, only a dozen of these were broad market trackers. The others were more or less exotic ETFs which can come in many forms:

• Narrowly sliced segments of the domestic market such as ETFs following solar stocks or nanotechnology (for example look at PXN / LINK). In many cases such market niches are dominated by only one or two index heavyweights and the investor takes a big single-stock risk because of this lack of diversification.
  

• Indexes on small, little capitalized emerging markets. An example here is last year’s launch of the MSCI All Peru Capped Index fund whose top-4 stocks make up 50% of the capitalization.
  

• Leveraged and inverse ETFs. These ETFs allow investors to gain or lose two to three times the direction of a particular index. But beware – these funds reset every day and can have unexpected outcomes. A good list of such funds can be found at the website Stock-Encyclopedia. However, doubling a series of daily returns is not the same thing as doubling the annual return of an index, so investors can wake up to a much worse than expected performance. Here is a link to an example of how the arithmetic for leveraged and short ETFs can work out.
  

• Futures contracts-based commodity ETFs like the United States Natural Gas ETF (UNG), sometimes known as exchange traded commodities (ETCs). These commodity ETFs will not track the spot price of the commodity in question so an investor can make the right call about the direction of the spot market but find that a futures-based ETF fails to deliver the expected returns. For instance, when the market is trading in a contango (future contracts are more expensive than the near contract or spot prices) commodity ETF investors incur a loss on every roll of contracts, as they sell a less valuable contract to buy a more expensive one.
  

• ETFs of ETFs. These funds of funds aggregate ETFs and create a layer on top of other ETFs. An example is the PowerShares Autonomic Growth NFA Global Asset Portfolio. This fund has an expense ratio of 0.25% plus acquired fund fees and expenses of 0.58% which adds up to total expenses of 0.83%. These funds of funds compound the fees and can become rather expensive. In addition, they may be very complex and opaque as the underlying indexes may ultimately consist of many thousands of securities.
  

Our general advice to investors is to avoid such products altogether. Overall, these ETFs prove to be much more advantageous to the fund sponsors than to the investors, as fees and spreads typically are much higher.

Of course, for the well-informed investor who can afford to spend the time researching the prospectuses of such funds there can be advantages. Leveraged short ETFs can hedge a portfolio on a daily basis. Exotic country funds can supplement a portfolio successfully if the investor has in-depth knowledge about the foreign market. Futures-based commodity ETFs can create nice returns if the investor is well informed about the trajectory of the future curve.

In conclusion, investors who don’t have the time to take a detailed look under the hood of such products or follow the relevant underlying esoteric indexes on a daily basis should definitely stick with the simple, broad-based market indexes. There are more than enough cheap, broad and liquid ETFs to get exposure to a well diversified portfolio of markets.