Wednesday, February 8, 2012

Safety tips for synthetic ETF use

Losing money is the fundamental risk for anyone buying any financial product. Whether a stock, bond, mutual fund, or ETF, investors have an expectation that information about these products will be correct, timely and complete. An entire industry has grown up around compliance and disclosure. Regulations for marketing and advertising investment products seem more rigorous than for lottery tickets that have a significantly lower expected return than most investment products and whose buyers appear less likely to afford losses. Go figure. Lotteries in Ontario alone account for about $3.8 billion in annual revenue with about half going to the government. I “Googled” tax on the stupid and “lottery” popped up. What then should we make of the higher regulatory scrutiny over mutual funds and the $10 billion plus of fees charged ($772.6 billion in assets @ 1.50%)?  
Investors know there are many ways to lose money. In looking at ETFs the risk of losing money can be broken into component parts.

Highest risk of losing money: costs
One never knows in advance what an investment’s return is going to be, but its cost is well known. Cost represents the greatest certainty of reducing capital for any product. Despite this obvious fact, it is stunning how many investors I’ve met have no real understanding of what they pay for products and services.
Some synthetic ETFs use swaps in their construction. In Canada these includes Horizon S&P/TSX 60 Index (HXT) and Horizons S&P 500 Index (HXS). Part of the cost of these products is the swap fee paid to counterparties to deliver the return of the underlying index. While the swap fee for HXT is listed as zero, interest and fees for securities lending likely provides the required margins. HXS bears a 0.30% fee. Investors should add this to the MER of 0.15%. The total expense ratio for HXT is 0.07%. These two ETFs offer a particular advantage for taxable investors by providing the total return of the underlying indices, the S&P/TSX 60 (HXT) and the S&P 500 (HXS). No taxable distributions are involved so capital compounds unfettered by tax.

Next highest risk of losing money: stupidity
Bet you thought this might be risk #1, but costs are certain. A stupid investor could actually get lucky once in a while!
Leveraged and inverse leveraged ETFs have been categorized as appropriate for daily trading only. This satisfies regulators and the compliance departments of brokerage firms even though the actual category should be “appropriate for daily trading only for dummies who won’t read the prospectus or bother to estimate volatility drag”. Otherwise intelligent people condemn these vehicles because compounding returns conceptually escapes them! Leveraged and inverse ETFs use synthetic structures although they are not listed in the table below. They form a subset of ETFs with embedded strategies. If you don’t understand a product, don’t buy it.

 Sometime risk of losing money: counterparty
Replicating an underlying index can be cumbersome. Some ETF sponsors choose to synthetically recreate performance. This involves posting collateral and having a counterparty (in Canada this means a bank) pledge the return. The quality of the counterparty and the liquidity and value of the collateral are the key points of concern for these ETFs. Synthetic structures involve fees that are classified as trading costs but should be considered as an overall cost of the structure.  
If one of the major banks fails as a counterparty, Canadians will have much more to worry about than just a synthetic ETF. Nevertheless, safeguards limit single counterparty exposure in Canada to 10%. In Europe, there is concern that ETF sponsors are using their own banks as counterparties. This has not happened in Canada yet. The risk of counterparty failure is difficult to assess. Just because it hasn’t happened here doesn’t mean it will never occur even if collateral in Canada is all cash. I learned from U.S. bond traders that some unquantifiable risks could be assessed as .05% on a trade. If one assumes that counterparty risk is 0.05% per annum, HXT’s actual-plus-notional cost would be 0.13% (0.08% TER plus 0.05% for counterparty risk). Over twenty years, the risk of a counterparty collapse with 100% cash collateral is 1.0%. This seems reasonable.
The table below shows all non-leveraged or inverse synthetic ETFs in Canada. Data is from a comprehensive report about ETF regulatory issues by National Bank Financial’s ETF team of Chiefalo, Straus and Zhang and is ranked by market value.

ETF Name
MV ($M)
Horizon S&P/TSX 60 Index
Claymore Advantaged High Yield Bond
Claymore Global Monthly Advantaged Dividend
Claymore Advantaged Canadian Bond Fund
Claymore Natural Gas Commodity
Claymore Broad Commodity
Horizon COMEX Silver
Horizon Betapro S&P 500 VIX Short Term  Futures Bull+
Horizon COMEX Gold
Horizon S&P 500 Index
Horizons Winter-term NYMEX Crude Oil
Horizon Betapro S&P 500 VIX Short Term Futures
Horizons Winter-term NYMEX Natural Gas
Synthetic structures are making useful products available to retail investors in cost effective packages. If you don’t understand these products or don’t want to do the research, may I commend lottery tickets or mutual funds for your consideration? Synthetic-based ETFs require more scrutiny. A little research will reveal valuable new strategies and products to you but you can’t pick them by using your spouse’s birth date.