City maverick Terry Smith, the founder of Fundsmith, has launched an attack on exchange-traded funds (ETFs), calling them "a new investment fad".
ETFs are open-ended index funds that are listed and traded on exchanges like stocks and last year saw huge growth in the number of ETF providers and funds.
"I think you should be very cautious about investment products that grow as fast as ETFs," he says. In his blog, Terry Smith Straight Talking, he warns of the dangers of synthetic ETFs.
While some ETFs replicate the performance of an index by purchasing a weighted package of all or most of its constituent securities, synthetic ETFs instead use so-called swap agreements with counterparties who agree to provide a monetary return which matches the underlying asset class or the index the ETF is seeking to track. "Can you be sure the counterparty will deliver?" he asks. "Some are using a single counterparty - just the bank that is running the ETF."
Synthetic ETFs are often used to access markets which are not directly accessible to retail investors such as the Chinese A-Share market or where liquidity in the underlying investments is poor such as equities in some emerging markets. "The opportunity for the performance of the ETF to diverge from the performance of the underlying assets and therefore from the investors' expectations in these cases seems obvious," he says. " The idea that a counterparty will provider you with a contract which matches the returns from underlying illiquid assets which you cannot directly own should give pause for thought - not least about how the counterparty will fulfil those obligations, for example in the case of extreme market movement and a liquidity crisis - a not unlikely combination."
He also warns of the "strange effects" of daily compounding experienced by some investors in leveraged ETFs which multiply index performance. For example, you can get to the point using a 2x leveraged ETF where the market is up 3 per cent but the ETF is down 15 per cent.
Here is how it works:
| Day 1 | Day 2 | Day 3 | Day 4 | |
|---|---|---|---|---|
| Index | 100 | 125 | 90 | 103 |
| Daily change | 25% | -28% | 14% | |
| Cumulative change | 25% | -10% | 3% | |
| Leveraged ETF (+2X) | 100 | 150 | 66 | 85 |
| Daily change | 50% | -56% | 29% | |
| Cumulative change | 50% | -34% | -15% |
Inverse ETFs which replicate a short position in an index can also produce perverse results. For example in a week where the index was volatile on the downside but got back to par by the end of the week an inverse ETF with daily compounding would turn in a 70.5 per cent loss.
Mr Smith says: "The moral of this is that these sorts of ETFs are really day-trading tools. If they are held for more than one day, they will begin to diverge from the performance of the underlying index or asset class."
