Are ETFs Becoming Pandora’s Boxes?

When I was working in institutional asset management, our team managed tactical asset-allocation strategies for pension funds. Initially, we used exchange-traded futures to implement strategies.

However, using futures presented a hidden challenge: they need to be rolled every month or quarter. There is often a cost involved in rolling a long or short futures position from the expiring contract into a new one. This can create a drag on performance. The drag may be small, but over time it can erode returns.

We then came across SPDR—pronounced “spider”—the exchange-traded fund that tracks the S&P 500. We began using it to obtain exposure to the US stock market, particularly because most of our mandates were unleveraged and therefore did not require us to rely on futures.

I had previously been responsible for executing all the futures trades and managing the rolls, so SPDR made my life much easier. SPDR now has assets under management of more than US$800 billion.

I used ETFs extensively when managing portfolios for private investors, starting with ETFs tracking major stock-market indices. I also used them to implement sector strategies. When factor-based ETFs became available, I used them to tilt asset allocations towards certain investment factors, such as value or quality.

Over the past few years, however, new types of investment strategy have increasingly been packaged as ETFs. Active ETFs have become a major area of product development for large fund-management houses. I recently attended an ETF conference, where nearly every company presented its latest active ETF offerings.

In Asia, single-stock ETFs have become particularly popular with retail investors. Many offer leveraged exposure to some of the most popular stocks in the AI and technology sectors.

These ETFs do not invest in an index covering the relevant sector. Instead, they track an index calculated from the daily return of a single stock, multiplied by a factor to create leverage. The inverse versions allow investors to take short exposure to the stock, often with leverage.

More recently, structured-product strategies have also been packaged as ETFs. These include “buffer ETFs”, which incorporate “supertracker” or “booster tracker” strategies previously used in structured notes. The latest innovations include ETFs linked to autocall strategies, which I will cover in the next edition of Tricio’s Monthly Insights.

Advisers and investors should exercise caution when considering these latest developments in ETFs. They are often marketed as cutting-edge innovations. Investors may also associate ETFs with lower costs than mainstream funds or other investment products.

Because they are ETFs, these products can be made available through many online brokerage platforms. This allows investors to trade during market hours, with visible prices and greater transparency. That flexibility is especially appealing to investors and advisers who dislike the offer-period and secondary-market limitations of structured investment products.

Here are three suggestions that may help investors avoid an ETF that becomes a Pandora’s box.

1. Identify and understand the index or rules-based process

Most ETFs either track an index or follow a rules-based investment process similar to an index. Regardless of the investment strategy, proposition or theme described in the marketing literature, investors should first identify the index or rules-based process underlying the ETF. Then investigate how it works:

- How is it constructed?

- What rules determine which securities may be included?

- What standards must those securities meet?

- Who determines the rules?

- Who calculates the index or determines the portfolio?

- Is the methodology publicly available?

- How frequently is the index or portfolio rebalanced?

Seek professional advice if you do not understand how the index or rules-based process works.

2. Treat back-testing with caution

Do not blindly rely on back-tests of the index or ETF presented in promotional materials. Many such tests are simulations based on assumptions that may not reflect actual historical conditions.

For example, the results may assume unrealistically low trading costs, narrow bid-offer spreads or no significant market disruption. It is important to understand what assumptions have been used and whether the strategy would have been practical to implement.

3. Consider the market conditions

Consider the market conditions under which the index—and therefore the ETF—is expected to deliver its intended outcome.

For example, a leveraged ETF linked to a stock may produce enhanced gains when the stock rises. However, it also magnifies losses when the stock falls. A 50% fall in the price of a stock requires a subsequent 100% gain merely to recover to its original level. The strategy may therefore require not only a rising market, but also relatively low volatility and a particular path of returns. Do those conditions match your view of the market?

ETFs remain useful and cost-effective instruments for investors to use in their portfolios. However, be careful when someone presents you with the next “innovative” ETF.

You may open a Pandora’s box if you do not understand what you are investing in.

James Chu, CFA

Head of Investment Solutions