This article was originally published in February 2012.
Losing money is a risk inherent in the purchase of any financial product. Therefore, be it a stock, bond, mutual fund or ETF, investors expect correct, timely and complete information.
Indeed, an entire industry has developed around compliance and disclosure. The risk of losing money in ETFs can be broken into three component parts:
- Cost
- Stupidity
- Counterparty/credit
Highest risk of losing money: Cost
One rarely knows the return of an investment beforehand; but the cost of that investment is very calculable, and represents the greatest certainty of reducing capital for any product. Despite this fact, it’s stunning how many investors have no real understanding of what they pay for products and services.
Some synthetic ETFs use swaps in their construction. In Canada these include Horizons 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 provide the required revenue. HXS bears a 0.30% fee. Investors should add this to an MER of 0.15% (0.45% total). The management 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) respectively. No taxable distributions are involved, so capital compounds unfettered by tax.
Next-highest risk of losing money: Stupidity
Costs are inevitable, making it the highest risk. Stupidity is the second because even a stupid investor can actually get lucky once in a while.
Leveraged and inverse-leveraged ETFs have been categorized as appropriate only for intraday trading. This satisfies regulators and compliance departments. However, they can be used for much longer-term portfolios but not by dummies who don’t read the prospectuses, or who don’t bother estimating the volatility drag.
Otherwise intelligent people condemn these vehicles because the idea of compounding returns must conceptually elude them. Leveraged and inverse ETFs use synthetic structures that form a subset of ETFs with embedded strategies.
It’s simple: if you don’t understand a product, don’t use it.
Potential 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 key concerns for these ETFs.
Synthetic structures involve fees that are classified as trading costs but should be considered an overall cost of the structure.
If one of the major banks fails as 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 are concerns ETF sponsors are using their own banks as counterparties.
This hasn’t happened in Canada yet. The risk of counterparty failure is difficult to assess. However, just because it hasn’t happened here doesn’t mean it never will—even if collateral in Canada consists of 100% cash.
HXT uses a swap with 10% exposure to National Bank Financial (NBF) as counterparty.
The spread between NBF and Government of Canada bonds is about 1.0%(3-year to 5-year), suggesting a potential credit risk of 0.10%. Add the MER, 0.07%, and the 0.17% compares with iShares S&P/TSX 60 Index (XIU) MER of 0.17%.
HXT’s 0.10% lower fee compensates the investor for the added risk. If HXT were structured as an exchange traded note, the entire 1.0% spread should be considered a cost.
Synthetic structures are making useful products available to retail investors in cost-effective packages (see “Canadian non-leveraged ETFs,” below). But synthetic-based ETFs require more scrutiny.
If you don’t understand these products or don’t want to do the research, you should probably stick with lottery tickets or mutual funds that require less sophistication. A little research will reveal valuable new strategies and products that are well worth the effort.
| ETF Name | Symbol | MV ($M) | MER (%) | Structure (swap fee) |
|---|---|---|---|---|
| Horizon S&P/TSX 60 Index | HXT | $326 | 0.07 | Swap (.00) |
| Claymore Advantaged High Yield Bond | CHB | $290 | 0.56 | Forward |
| Claymore Global Monthly Advantaged Dividend | CYH | $128 | 0.56 | Forward |
| Claymore Advantaged Canadian Bond Fund | CAB | $118 | 0.30 | Forward |
| Claymore Natural Gas Commodity | GAS | $94 | 0.90 | Forward |
| Claymore Broad Commodity | CBR | $45 | 0.93 | Forward |
| Horizon COMEX Silver | HUZ | $18 | 0.65 | Forward |
| Horizon Betapro S&P 500 VIX Short Term Futures Bull+ | HVU | $18 | 1.15 | Forward |
| Horizon COMEX Gold | HUG | $15 | 0.65 | Forward |
| Horizon S&P 500 Index | HXS | $11 | 0.15 | Swap (.30) |
| Horizons Winter-term NYMEX Crude Oil | HUC | $4 | 0.75 | Forward |
| Horizon Betapro S&P 500 VIX Short Term Futures | HUV | $2 | 0.85 | Forward |
| Horizons Winter-term NYMEX Natural Gas | HUN | $1 | 0.75 | Forward |
Source: Derived from research by National Bank Financial, Pat Chiefalo, Daniel Straus and Ling Zhang. Ranked by market value.