Holly Cook: For Morningstar, I'm Holly Cook. Recently the FSA sent a factsheet to investment advisers telling them about the risks that they need to be aware of if they are considering recommending ETFs. I'm joined today by Gordon Rose. He is an ETF analyst here, and he is going to tell us what you need to know about ETFs, whether you're an adviser considering recommending them or an individual considering buying them.
Gordon, thanks very much for joining me.
Gordon Rose: Pleasure.
Cook: So what might be the hard-and-fast rules that investors needs to know about ETFs?
Rose: I mean generally there is a lot of criteria you would want to consider, as outlined in factsheet, but I think the main three criteria is knowing your index, understanding the structure the ETF is using to replicate the index and also assessing the total cost of ownership.
Cook: Okay. So let's take them one by one maybe. The first one—understanding the index—can you explain more about that?
Rose: Yeah. I mean what an investor wants to look at is the index weighting methodology and also look at concentration risk within the index. So, most indices are using market capitalisation-weighted methodology. That means that larger companies experience a higher weighting within the index. That obviously can lead to high concentration risk as seen in the tech bubble where you have a very high concentration to overvalued stocks, and so investors just need to keep that in mind. On the concentration level for the sector or individual constituent is also very important to determine whether it actually fits within the investment objective and also to understand underlying economic risk. So let's take an example of the MSCI Brazil; you as an investor want to take part in the growing middle class, which is increasingly affordable.. or can afford new products, and you want to invest in that strategy by buying the MSCI Brazil. But if you look at the MSCI Brazil, you have about 20% - almost 20% - in Petrobras, the oil giant, and as we have seen in 2010 with the BP oil spill that can have a huge risk. And on the sector allocation you have a lot of sectors [in the MSCI Brazil] related to commodities which are more driven, maybe, or dependent on, by the Chinese economy. So, it's not actually fitting with the investment objective. So, you want to investigate on these two levels as well.
Cook: So, it's not just understanding what's in the index but also what affects the index as well?
Rose: Yes.
Cook: So, how about the second point, the structure of the ETF?
Rose: I mean, obviously, ETF providers they can use two structures, the physical replication or the synthetic replication to track the performance of the index. With the physical replication, you can do either full replication or sampling replication. For full replication you obviously buy the entire index, which you would usually do for relatively small, high liquid indices like the FTSE 100 or the Euro Stoxx 50. For more larger and less liquid indices, you do optimised sampling, where you just buy a part of the index constituents. An example would be the MSCI Emerging Market. Optimised sampling works relatively well in normal market conditions but if you have adverse market conditions, or a market shock like we had with the financial crisis, this can lead to much higher tracking error than you would have otherwise expected. So you need to understand these risks as well. And many ETFs using physical replication also do securities lending and to generate an extra income for investor, but at the same time it will also appear some counterparty risks. Then you have the synthetic replication, where actually the ETF provider enters into a swap agreement for multiple or a single counterparty and they basically agree to swap the return of a predefined basket of securities with the return of the underlying index. This obviously introduces counterparty risk as well, but at the same time synthetic ETFs usually have a better tracking and a lower TER [total expense ratio]. So synthetic ETFs are probably a better choice in relatively illiquid and hard to access markets compared to physical replicated ETFs.
Cook: Okay, and then the final point what you term as the cost of ownership?
Rose: Yeah. I mean there is a lot of cost that's coming actually on top of the total expense ratio outlined in the factsheets and they are costs like with any other investments: brokerage fee, bid and offer spread, premium or discount to NAV, and so you just have to shop around a little bit to get the best deal, but then you also have the tracking error which is an implicit cost of your total cost of ownership. With physical ETFs, they obviously incur a lot of training costs due to the rebalancing of the underlying index and also the timing of the dividend might increase the tracking error of physical replicated ETFs, because there is a time lag between receiving the dividends from the index or from index constituents and paying out to the investors. During that time, the dividends are not invested and that can create a so called ‘cash drag’. That would lead to an underperformance at an up-trending market, but at the same time would lead to an outperformance in a down-trending market.
Cook: Okay. So on top of these three rules that you need to address first, are there any other top tips that you would have for investors?
Rose: I mean generally it goes with every other investment: You just need to know what you're buying and you need understand the risks and the underlying economic drivers, and how it all fits together just to get it into the context of your portfolio that you don't get any surprises you don't want to.
Cook: And specifically for advisers who've received the FSA factsheet, is there anything particularly that would highlight from that?
Rose: I mean generally they are very valid points to assess an ETF, but these points are valid for many other investments as well, so it's not just ETF specific. And I think also what comes a little bit short in that factsheet is the fact that one of the main risks you're getting through an ETF is actually the underlying economic exposure gained through that index you're tracking and that is a very important fact to consider, as well, as I mentioned earlier.
Cook: So none of these factors that we've discussed need be negatives, it's just things that you need to be aware of?
Rose: Yeah. In finance it's always about balancing the risk-return to your own investment objectives.
Cook: Gordon thanks very much for joining us and for explaining these for us.
Rose: Thank you.
Cook: For Morningstar, I’m Holly Cook. Thanks for watching.
