Advisors must understand risks of certain ETFs

“This is a space that has seen tremendous growth and a lot of product has been thrown at investors,” says Yves Rebetez, managing director at ETF Insight, adding there are now more that 250 ETFs in Canada. “The big issue is to ensure that end-users get to be made more aware of what strategies can be implemented with ETFs.”

Mark Yamada, president and CEO of PUR Investing, agrees. “The kinds of strategies that remain to be offered through this space have to be offered through active ETFs. Many of these strategies are not what would we believe would be actively managed,” he notes, but they offer an opportunity to take a different angle on risk, particularly in fixed income.

Still, they’re not for everyone. Pauline Shum, a finance professor at York University’s Schulich School of business, says active ETFs would still have to go through the manager due-diligence process for pension plans.

Adds Yamada, “If you’re an institution that can replicate many of these indices, reasonably inexpensively and at a low dollar rate, there’s probably less value. For the retail investor and for the advisor looking to use ETFs, what’s really important to the end-client is managing losses.”

The greatest contributor to controllable losses is cost, he explains. “If a mutual fund is charging 200 basis points and the ETF is charging 15, the greatest certainty of loss is what that manager is going to put in her pocket every year.”

Yet, for all their advantages, ETFs make up 10% of the dollar value of mutual fund assets in the U.S. — and in Canada only 6%.

The reason, says Yamada, is compensation. “The only thing standing between a superior product and the end-user is the advisor, and the advisor has to get paid. He suggests that perhaps 10% of advisors are committed to using ETFs – enough to create a groundswell, but not enough to change the dominance of mutual funds.

A final issue is the growing complexity of ETFs. With the use of derivatives or the introduction of covered call writing: the strategies that are emerging require some effort to understand.

Read: The facts about covered call options

Shum points to TVIX, an exchange-traded note that tracks S&P 500 VIX Short-Term Futures Index. It’s essentially a credit product that trades on a stock exchange. “It was trading at a 90% premium but investors did not know that,” he says. “Unless you are a professional money manager, you don’t have Bloomberg in front of you and you don’t know about the premiums and discounts because in all the literature that you read it’s a very smooth process.”

But in this instance, she says, the provider stopped creating new notes, so the premium gapped out. That’s different from the usual ETF process, where authorized participants buy and redeem creation units to eliminate premiums and discounts.

For example, if an ETF is trading at a premium, an authorized participant will buy the underlying shares and get an ETF unit in exchange, putting downward pressure on the ETF price. But with the ETN, the bank halted new note issuance because it couldn’t hedge its own exposure.

The concern with covered-call ETFs, on the other hand, is that advisors may not be licensed for options trading and thus may not fully understand the product.

“Just because you’re not licenced for writing options within the strategy, you’re not exempted from the responsibility to ensure that you perform [suitability] due diligence,” warns Rebetez, pointing to a 2001 U.S. action in which Massachusetts’ regulator sued RBC Capital over inappropriate sales of leveraged ETFs.

He concedes, “It’s probably a good offsetting attribute that ETFs offer specialization in options” to allow for diversification.

Yamada is more critical. “To a certain extent, covered-call products fall into this meaning of regulatory arbitrage,” saying most managers don’t understand the risk, dynamics and timing of such products.