Terry Smith Warns Of ETF Dangers

In an effort to be clear, my criticisms of ETFs are: ETF

ETFs are almost certainly being mis-sold. My straw poll of investment professionals suggests that many investors think that ETFs are simply index funds. Many are not. Synthetic ETFs do not hold underlying securities of the sector or market they are supposed to replicate. Inverse ETFs can lose money even when the market sector they track has gone down, and leveraged long ETFs can lose money when their market or sector has gone up. None of these is consistent with the performance of a simple index fund.

Synthetic ETFs are of particular concern. If a fund which is described by the words synthetic, derivative, swap and counterparty does not cause you obvious concerns, I suggest you may need to study the events of the credit crisis of the past four years more carefully.

Because ETFs are tradable on markets unlike mutual funds, traders can sell them short. Relying upon the assumed ability to create more shares in the ETF in order to close these short sales, it is not unknown for the short interest in certain ETFs to reach ten times the size of the underlying ETF’s assets.

In these circumstances, the average ETF holder may be unaware that only some 10% of their holding in the ETF is represented by assets of the type they expect-the other 90% is a promise to deliver units from the short sellers. All will be well unless the short sellers find it difficult or impossible to buy enough of the underlying securities to deliver the required ETF shares which in some illiquid index or sector ETFs is entirely possible.

One more problem with ETFs became apparent to me in the course of this debate. ETFs are represented as low-cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks.

This seems counter intuitive: how does a low-cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides.

They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury.

My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets. But if you decide this is correct, buy precisely that, an index fund, not an ETF.

The only difference between a physical ETF (which frankly is the only sort you should contemplate unless you like the risk of synthetic derivative swaps with counterparty risk) and an index fund is that the ETF is traded on the market as the term “Exchange Traded” implies.

Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don’t want active management, and mostly you shouldn’t, buy an index fund.

Terry Smith

Source : Fundsmith – Annual Letter to Shareholders 2011