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Thursday 25 June 2009

Exotic ETFs Are Toxic ETFs

Beware of Enticing Charms

Just as the exotic charms of Cleopatra confounded Julius Caesar, the foreign wiles of Delilah did for Samson and the mystique of Heather Mills’ fake leg ensnared Paul McCartney, so the mysterious allure of the exotic ETF is undermining the original purpose of these investment vehicles. As usual the investment industry has worked its magic and turned a really useful investment tool into a method for speculating in snake oil.

From single country funds with markets no bigger than the market capitalisation of a newly downsized investment bank to Ultra Short ETFs that ensure you have a whole new set of ways to lose money these things are dangerous for private investors. However attractive they may look, beneath the surface they’re toxic waste, not investment gold.

Getting Active With ETFs

Historically ETF’s were index funds, although it’s no longer the case that ETF equals index. This is, in itself, a danger for the unwary who wander into the investment thicket without protective clothing – or at least, having engaged their pre-frontal cortex. This trend is new, but it’s unlikely to go away.

The underlying beauty of ETF’s is in their transparent structure, low fees and share-like properties, where they can be bought and sold like equities on open markets. This is also their biggest weakness, since it’s a given that if an investor can actively trade a security then the securities industry will invent reasons to induce them to do so. And indeed, this is proving to be the case as increasing numbers of short-term focused investors use ETF’s to implement active and, heaven help us, hedging strategies. It’s no longer about passive investment, you see, it’s about active asset class management. Or, as we like to say around here, it’s about “being stupid”.

The Rise of ETFs

ETFs have only really been around since 1993, when the American Stock Exchange launched Spiders, still the largest ETF in the world, tracking the S&P 500. Other broad based market index tracking ETF’s followed, notably the Barclays iShares MSCI country specific ETFs providing US investors with a way of directly investing in overseas market indexes.

Soon fund management companies cottoned on to the idea that ETFs were a new way of repackaging old hooey and started generating new indexes to track against. Now, if we stand back from this and think a minute we might register the fact that all indexes are man-made creations. They don’t exist in and of themselves, we have to go out of our way to manufacture them by grouping companies under some convention such as market capitalisation. So, in theory, there’s no problem in manufacturing new indexes to benchmark against.

Making Up New Indexes

However, there’s an issue here. It’s one thing creating Spiders to track the S&P 500 and QQQQ to track the Nasdaq but it’s entirely another thing inventing an index to track investments in green energy or companies that have sustainable competitive advantages or child-friendly war games. Although, arguably, tracking on market capitalisation is as much a creation of the human mind as any of these other synthesised indexes there’s an awfully big difference between tracking something that already exists and creating something to track against.

The problem here is that someone is making up categories against which to create an ETF and, unfortunately, the categories aren’t out there in the real world; they’re inside that person’s head. Typically they’ll also be inside other people’s heads as well which why others buy them but that doesn’t make them any more real or suitable for investors. Philosophers have argued over what constitutes a category ever since Aristotle and are no closer to a resolution now than they’ve ever been.

Put simply, someone’s inventing investment categories based on some plausible explanation and then selling it to people as something real. All this ends up doing is giving people who don’t understand the difference between investment analysis and a thumping good story the opportunity to get in late on the next investment trend and sell out late on the last.

Exotic EFTs

However, having got the idea that there was a market for these things, appealing to the narrative obsessed, story loving, mid-brain following investment masses, the securities industry decided that having pushed a good idea to the edge of the cliff, they might as well shove it over and see what kind of satisfying noise it made at the bottom. So were born Exotic ETFs like Exchange Traded Commodities, Exchange Traded Notes and the ability not just to short any one of a number of these creations but to ultra short them.

So-called Exotic ETFs are simply those exchange traded vehicles that track stuff that should never have been invented, let alone tracked. Some of these are simply stupid indexes like the one that tracks Belgium, a much underrated country but one whose main products are European Union Regulations, chocolates, French fries and blonde beer. Others aim to simulate the world of hedge funds by investing in other ETFs in order to replicate the successes of the hedge fund managers. So the idea, presumably, is to make a lot of money quickly and then retire before the funds collapse.

ETNs and ETCs

A simple idea like an ETF is too transparent to generate significant fees so it’s better to wrap the concept up in something else like an ETN – an Exchange Traded Note. In fact these are debt and underwritten by some organisation, usually a bank, which as we know never go bust. Well hardly ever. So they’re obviously nice and safe then, despite looking and trading like an ETF.

You can also invest in commodities through Exchange Traded Commodities (ETCs), a concept which has attracted huge interest in the last few years, presumably on the normal investing principle of “let’s buy stuff that’s gone up a lot because it’s bound to carry on doing so forever”. Some of the ETCs were underwritten the giant insurer AIG. When AIG ran into financial trouble the reality of this relationship meant that holders of the ETC’s, most of whom thought they were investing in copper or oil or something, discovered that they were potentially creditors of the biggest bankrupt insurer in the history of the world. With exotic securities it’s important to know who the counterparty really is.

Hot Pants – Ultra Shorts

Last, but by no means least, we have the concept of short ETFs which will sell short whatever it is you don’t like or even Ultra shorts which aren’t a new version of hot pants but are mechanisms that mean you double your gains as markets fall. Or double your losses as they rise.

Sensible investors shouldn’t go near any of this stuff. If you’re going to invest in some esoteric sector then actually doing some research to determine the macroeconomic reasons for doing so and then some more research to find the companies that give you the best exposure is the only real way of achieving what you want. Expecting some idiot in a room who’s artificially concocting an index to do this for you isn’t investing, it’s gambling.

Get Out The Knives

If you’re investing in broader markets based on market capitalisation or on some other proper analytic basis that doesn’t rely on someone making up indexes then ETFs are a good way of getting buy and hold exposure. The rest of this stuff is just a new way for investors to lose money by believing stories without doing proper analysis while thinking they’re spreading their risk by buying an index.

Just like the famous men who’ve fallen prey to exotic tastes, anyone investing using Exotic ETFs will likely to come to an unfortunate end.

Related Articles: Don't Give Index Trackers The Bird, You Can't Trust The Experts With Your Investments, Fairy Tales For Investors


  1. Excellent stuff.
    A great example of how financial institutions take a simple idea and complexify it in order to charge more.

  2. It's typical Wall Street. Money for themselves and nobody cares about the invetor.

    Prediction: Why stop at 3X funds. The quands and quints ae next. And what about the 10X ETF?

  3. Just for fun, I don't 100% agree Timarr.

    Obviously vast quantities of your post is bang on the money. And versus passive index investing in the broadest market possible, a la Bogle, then everything but big national marketwide ETFs are clearly an anaethma.

    But I do think there's a place between ISF (the iShares FTSE tracker) and buying shares in BP or Shell, let alone Dana Petroleum or Shell.

    Sometimes people do want exposure to an asset class or theme or sector. Repeatedly over the years I've seen sector wide movements be much more important than stock picking within that sector.

    I think not-too-exotic ETFs are a valid way for some investors to get such exposure.

    The ultra-short and leveraged stuff is much worse than it sounds - and then you imply. They're closed daily, so if the market doubles in three months, you won't perforce get twice that doubling, it all depends on how the market closed on all the days in between (and more, to do with the cost of debt etc, which I won't pretend to have fully investigated).

    Now that's a truly toxic ETF. :)

  4. And just for fun I'll respond :)

    Munger said something along the lines that he never saw anyone get rich through sector selection. However, I don't see anything wrong in mining ETFs or pharma ETFs or the like - perfectly fine ways of constructing a portfolio. Where it goes horribly wrong is when you start getting ETFs constructed on artifical categories designed to appeal to investor sentiment - designer ETFs if you like. The problem is that the designation "ETF" for most people implies some level of sensible stability, almost a synonym for index tracking. Only it's not.

    The ultra-leveraged stuff is ultra amazing as you point out. Toxicity personified. More on that another day!

  5. Hi,

    Just found this blog and I like it a lot. However you should point out that leveraged ETFs do have their place in knowledgeable investors' portfolios, but not as part of a buy and hold strategy. They replicate a multiple of daily results, leading to path dependent returns, and their issuers explain this clearly. Explaining their usefulness as vehicles for taking short-term views is much more productive than labeling them as toxic.