Blooming ETFs should be handled with care

Exchange traded funds (ETFs) seem to bloom seasonally. Through the winter, nothing much new appears. Then, come spring and early autumn, new ETFs are everywhere – a few useful, most pointless.

At an ETF conference in tulip-filled Amsterdam last week, I discovered that there are now 55 ETFs tracking the Dow Jones EuroStoxx 50 index. But all this competition is not necessarily good for all investors. Market makers have to keep these stocks on their books so, as choice increases, costs for the least liquid funds (in terms of the bid-offer spread between the quoted buying and selling prices) creep up.

However, more choice can bring genuinely new investment ideas. Take, for example, two new ETFs from Source and Deutsche DBX Trackers.

Source has provided a low-cost way to move back and forth between different market sectors, depending on the economic cycle. This is an old trading idea. When an economy is coming out of recession, you invest in super-cyclicals such as miners. But these are not the best stocks ahead of a cautious phase when the growth rate subsides. In this latter scenario, you probably want a more defensive allocation that consists of utilities or pharma stocks that can keep paying generous dividends backed by regulated cashflows.

This shift from cyclicals to defensives is one of the core strategies of active fund managers, such as Tim Russell from Cazenove, who tries to work out the “turning point” in any cycle.

Source has now acknowledged this strategy by launching its Market Quartile ETFs, based on the Stoxx Europe 600 index. As their name suggests, they in effect divide the index into four: defensives, cyclicals, consumer discretionary and staples. They offer exposure to these stocks by tracking the equivalent Stoxx Europe sub-index.

Right now, I quite like the steady-as-she-goes qualities of the consumer staples ETF. Buy it and you get exposure to Nestlé (10.2 per cent), Unilever (7.1 per cent), British American Tobacco (6.9 per cent) and Tesco (6.3 per cent). My more cautious side also likes the defensives ETF, which holds big pharma stocks such as Novartis (6.7 per cent) and Roche (5.1 per cent) – plus oil companies Total (5.9 per cent) and BP (5.5 per cent). If there is a double dip recession, expect both the staples and defensives to fall less than the more racy sectors.

Deutsche’s new db-x ETFs arguably need to be treated with greater care. They are leveraged index trackers that will return two times the change in indices, such as the Dax and the FTSE. In the US, 2x leveraged ETFs, and even 3x leveraged funds, are hugely popular.

Deutsche’s leveraged ETFs are being aimed at institutional investors but anyone can buy them – although that doesn’t mean everyone should. In fact, in the US, these leveraged ETFs have been the subject of much critical scrutiny from regulators as investors have piled into them thinking they will simply amplify the overall trend return of an index. For example, if the market is up 4 per cent, the ETF will rise 8 per cent.

Unfortunately, there is a flaw in that reasoning. These leveraged ETFs track daily returns – and, on a daily basis, losses can have a greater effect than gains. Take a 2x leveraged “bear” ETF, which tracks an index inversely. Say, on day one, the index rises 4 per cent. Your initial 100p investment falls to 92p. The next day the index falls 4 per cent. Your ETF will then rise – but closer to 99p, not 100p. Extend this zigzagging over weeks or months, and the index could end up where it started but both a 2x bull and a 2x bear fund would end up down in price.

It is a function of volatility and compounding. If volatility is low and the trend is strong, these leveraged ETFs can be a superb way of capturing super-sized returns. But you need to know they can self-destruct. Be warned and use with care.

adventurous@ft.com

Commodity index trackers: New launches to note

Competition in the commodity tracker space
is also hotting up. French bank Société Générale (SG) – which offers ETFs under the Lyxor brand – is about to launch a range of 16 new exchange-traded notes (ETNs).

These will be similar to the types of tracker offered by ETF Securities, in that they will rely on a bank counterparty to provide the index return – which keeps cost and tracking error down but adds risk.

SG’s ETNs will comprise trackers on a range of commodities from crude oil to zinc – including the S&P/GS Global Agriculture index, which ETF Securities also tracks.

Total expense ratios (TERs) for the new ETNs are expected to vary between 30 and 50 basis points but there’s one key point to note: SG will take out the currency fluctuations of tracking dollar-quoted commodity indices. It will do this using a process called “Quanto”, which carries out daily hedging, charged at a cost to the customer.

Back-testing indicates that the net hedging cost for its gold ETN over the past three years would have been 1.17 per cent a year
– and, across the range, investors can expect to incur hedging costs of between 1 and 5 per cent, depending on volatility. This is on top of the TER but it does remove the currency risk, which will be attractive to some investors. Expect full details of the ETNs in the next two weeks.