Do non-traditional ETFs belong in client portfolios?

The following edited transcript is from “Do non-traditional ETFs belong in client portfolios?” an InvestmentNews webcast held Oct. 6. Deputy editor Evan Cooper and reporter David Hoffman moderated.
InvestmentNews: How concerned should advisers be over the attention that leveraged and inverse exchange-traded funds have received from organizations such as the Financial Industry Regulatory Authority Inc.?

Mr. Carr: These products are very much on the radar right now of Finra and the [Securities and Exchange Commission] and some of the states. Advisers have to make sure that they’re documenting that the ETFs they are using are suitable and appropriate for their clients. The SEC or the states are coming around and reviewing your documents and reviewing your files. It’s incumbent on you — because you know it could be coming down the pipe — to document that the ETF you are utilizing in the client portfolio is suitable and appropriate.

Ms. Moriarty: I completely agree with what John said. And I would really encourage potential investors to at least read the summary portions of the prospectus, because in all of the leveraged and ETF prospectuses now, they give actual examples, either in the front part of the prospectus or in the back, of how the mechanism works — if you bought it here and you sold it there, or how a bad market or a good market works, and length of time and duration. All of that is very, very important. Half the problem is that people don’t understand what they’re investing in. And then they’re very disappointed when it works out to be something it isn’t.

InvestmentNews: Are they comprehensible? Can people figure them out?

Ms. Moriarty: The SEC recently made the providers put those examples in. So they’re really pretty much plain-English. It’s pretty understandable.

Mr. Carr: There is a Finra Notice 0931 from June that gives some examples of non-traditional ETFs. I would encourage everyone to read through that. There are similar things on the New York Stock Exchange site and the SEC site that give some examples.

InvestmentNews: Do your investors read those documents? And do you think they serve their purpose?

Mr. Schatz: First of all, I don’t think any investor working with an adviser sits down and reads prospectuses. I’d be kind of shocked if they did. And I’d be curious as to why they did, because they hire us to do that for them. But let’s call a spade a spade. This is nine years in the making. Inverse and leveraged mutual funds were around in the late “90s. So it’s a little troubling that it took 10 years and an absolute collapse in the system for the powers that be to pay attention. Nothing is perfect. The shortfalls only come out when things really hit the fan. So are my investors reading it? No. Are they concerned about it? They’re concerned about it if I say, “I think we should be concerned about this.” But more conventional ones, like some of the junk bond ETFs, have got inherent problems as well that people aren’t talking about. And I just wonder, do we have to have a crisis for these problems to come into the mainstream?

Mr. Simon: What ends up happening when you get in markets like we’ve had in the last year and a half is that all of a sudden, inverse ETFs became something that people could utilize to manage some of their downside risk. And people have to be very careful — just like [with] medicine. Prescription drugs can be bad for you if they’re misused, but they can do wonderful things if they’re applied to the right situation. When looking at the ETF market, you really have to take that same approach. While our investors don’t read those prospectuses, because they’re relying on us to do that as their adviser, we do look at the construction methodology on how these ETFs are actually put together. That’s very, very important. If you don’t do that homework first, you get a negative surprise.

InvestmentNews: Have these ETFs performed pretty much as you have expected?

Mr. Schatz: For the most part, yes. However, if you really dial down to the double- and triple-leveraged funds, both the long and the shorts got hammered last year because of the compounding effect, to say it nicely. So you could see a double-leveraged long fund and a leveraged short fund both go down more than 50% in one year. And most people would say they were surprised about that.

Mr. Simon: When you’re going to a two- or three-X, whether it’s an inverse or a leveraged situation with one of these ETFs, they’re inherently going to be more volatile. But in a situation like the last 18 months, where volatility was unprecedented, it’s basically like throwing gasoline onto a fire. What surprised a lot of people were just the extreme movements that we saw day to day in the markets: 20% to 30% moves within a day just absolutely blew people’s minds. That’s one of the reasons you have to be careful. You have to do your homework.

InvestmentNews: Is that a structural flaw of these ETFs or is it an effect of the market?

Ms. Moriarty: If you look at the prospectuses, they all say on the first page what it is they’re trying to do in daily performance. But people didn’t really pay attention to that. They figured if they held a double-down fund, it would give them a double-down performance over the entire period that they held. But because of the way compounding works and because the investments are changing every day, it doesn’t work that way. So the disclosures now make it clear that performance is only for the period that’s mentioned, which is usually a daily period.

InvestmentNews: If you go to the white-paper section of our website, you’ll see one about ETF construction. So the issue seems to be one of ignorance. People just aren’t aware of how they’re constructed.

Ms. Moriarty: The very first ETF was very simple to understand because it was basically a complete replication of the S&P 500. And that was pretty easy to explain to people. All of the first ETFs were simple equity investments in either the whole or a sampled replication of the underlying index. After a while, everybody just said, an ETF is a really simple thing. You just buy it, and you hold on to it, then you sell it. And it’s better than a mutual fund because it’s cheaper, and you can see what you’re doing. And you can buy it or sell it within the day, not at [net asset value] once a day, which was very attractive for a lot of people.

Then, as the industry began to create more-sophisticated products, people weren’t really aware of the difference between the two of them. Even today, there are products that are seemingly the same. There are three different products that all hold gold, yet each of them is slightly different. The differences may or may not make a difference to you personally, but you should be aware of them if you are going to buy them, because they do make a difference. Each of them has been structured for a particular reason. It’s not bad or good; they’ve just chosen different ways to accomplish more or less the same purpose. But each of those ways has a slightly different effect.

InvestmentNews: Given the fact that these are sophisticated products and need to be used carefully, tell us a little bit about how you use them.

Mr. Schatz: Let me fully disclose upfront that I rarely, if ever, use the two-X or three-X ETFs. I do use inverse ETFs and more the non- traditional ones. We run two international portfolios where we have very concentrated positions in a couple of countries. For instance, we’ll be long in Brazil and China, and we’ll hedge that. Or on the developed-market side, we’ll be long Great Britain and Canada, and we may at one time or another hedge it. We’re normally a directional firm. But at certain times, we’ll hedge with the inverse ETFs. The hedges are normally short-term, anywhere from one day to 10 days. And then we run a longer-term portfolio, our global asset allocation strategy. It’s all ETFs that include commodities, real estate, currencies, from the long side only. So we’ll have equities, fixed income, currencies, commodities, real estate and private equity all in one portfolio.

Mr. Simon: We have three long-only global portfolios that are tactical. Then we also have one hedge fund called the TAG Fusion Fund. In the hedge fund, we have used on a very limited basis some of the levered ETFs. We use those on part of the fund as debt that we allocate to short-term trading strategies. For that slice of the pie, we’re able to trade shorter-term — it could be a day or two, up to maybe two weeks.

Where I’m really excited for not only us but for other investors is some of the other non-traditional-type ETFs like commodities and currencies in individual countries. You can now get exposure to strategies that in the past were only available to endowments or pension and hedge funds and were expensive, because you had to actually go and open up a futures account. Until the last several years, the door was shut on these asset classes or other non-correlated-type investments.

So the fact that you can now go out and buy a broad-based commodity index or drill down and own silver or gold or copper just allows people to hedge risks in their portfolio. You can hedge political risks, economic risks and of course potentially increase the returns on your portfolio. That combination can be pretty powerful.

In terms of commodity ETFs and ETNs, and some of the risks, I would just say that you don’t actually own physical commodities; you own a promissory note whereby you as the investor put your money into the exchange-traded note, and Barclays [Global Investors] will guarantee the return of whatever that index does. The issue is, you have to look at the credit quality rating of the actual issuer, which is Barclays, and there could be some credit risks that you could have as an investor if for some reason Barclays were to have financial trouble and could not deliver on the return.

The second thing is, recently, the [Commodity Futures Trading Commission] has talked about putting position limits on certain types of commodity exchange-traded funds. As a result, some of the exchange-traded-fund issuers decided not to issue their shares. So you have to be careful because there are some regulatory risks in some of these commodity ETFs.

And that’s something that we’re managing really closely because there could be some rulings that come down that could negatively affect those ETFs going forward. But we think it’s a tremendous opportunity for people to be able to enter into areas that they just otherwise were shut out from years ago.

Mr. Simon: It’s not only commodity risks; it can happen with equities as well when you’re dealing with foreign countries. I’ll just add, all of these commodities have a place. The issue is, people buy them before they understand how they’re constructed. Most of them don’t follow the spot price of gold or oil or sugar basis point by basis point. So there’s a futures role involved in some of these. Each commodity has different construction. You really have to understand what you’re buying before you buy it to make sure it belongs in a portfolio.

InvestmentNews: Some have suggested that what’s been going on with the CFTC and commodities exchange-traded products could actually spell the end of commodities products, at least those that rely on futures.

Ms. Moriarty: It’s a very complicated and confused situation. There are certain commodities — exchange-traded products, usually the metals funds — that actually invest in the underlying physical commodity itself, and don’t invest in futures. So the gold funds actually invest in bullion.

However, oil funds and hogs and other things are obviously invested in futures, not in the underlying commodity. The CFTC has jurisdiction over futures traded on those commodities. It does not have jurisdiction on the actual metal if it’s just sold or bought directly. So the CFTC doesn’t want to have much to say about the metals funds, but it certainly does have a lot to say about the other kinds of funds. And many of them are commodity pools, so they are very regulated by the CFTC.

The position limits did cause a great deal of consternation in the context of the [United States Natural Gas Fund LP] and were the subject of a bunch of hearings and discussions. And it’s not clear what’s going to happen. On the one hand, you could argue that if they do impose position limits, you’re going to have people who will be shut out of the market again.

The problem is a perceived radical increase in pricing, and the question is, were the commodity ETCs responsible for this or were general market situations responsible for it? Were the ETCs just following that market trend, or the cause of the trend? So it’s hard to know exactly what’s going to happen.

Mr. Schatz: As a lawyer, do you have any concern that in some cases, where they say the metal is backing the ETF, that that actually isn’t the case?

Ms. Moriarty: In the case of the funds that I represent, those vaults are audited twice a year. One of the audits is scheduled, so theoretically, they could shovel in gold that has never been there before for the auditors. The other time, it’s a surprise audit. So it’s less likely that they could rig that. On the other hand, who knows? Maybe there could be a situation where those assets are not there. And the only way you could protect against that would be to have an independent person posting guard 24/7 for the entire year. The cost of that would be so enormous that it probably wouldn’t make any sense.

Also, the people storing the gold are big players in the gold market. These people hold gold as a matter of course. They’re not special people who have been designated to hold these gold assets; they’re the people who hold gold for the entire industry. So I’m an optimist; I tend to think they’re safe. But I couldn’t swear on a stack of bibles that no one could figure out a way to get the gold, I suppose.

InvestmentNews: Going back to the exchange-traded products that are using futures to get their access to commodities, do you see that there’s anything else they could do? There’s been a lot of talk about these products’ finding a different way to get that access.

Ms. Moriarty: I know that the [gas fund] started to invest more in swaps. I don’t know whether they’re back to buying the futures contracts or not. If you look at their prospectus, there are about 12 different kinds of instruments that they can invest in. They actually have a lot of latitude as to what they could invest in.

The question is, how close are those things to the thing they’re really tracking? If you’re tracking West Texas intermediate, then obviously, the thing that will track it most closely is West Texas intermediate. But you may be able to buy some other kind of crude oil, saying that it’s close to that, and manage that with some other things to give you the same result. Or you might be able to arrange a swap contract.

So I’m not concerned that these will disappear. I know the bankers too well. They always figure something out.

InvestmentNews: There was an announcement from one of the providers about moving the leveraged and inverse ETFs to monthly investment results versus, say, the daily results.

Mr. Simon: That is a good move. We’ve seen a handful of claims coming in regarding some of these inverse and times-two ETFs, and I think almost all of the problem would have been solved if it were more of a 30-day-type of deal as opposed to daily. Certainly, the alleged loss would have been a lot smaller.

Ms. Moriarty: When you’re talking about a daily ETF, everybody gets the same price because everybody has something that is being turned over every day. So they all have the same experience. However, when you go to a month, the people who buy on the first day of the month do not have the same experience as people who buy on the second day of the month or the 15th or the 30th. So it’s not necessarily a problem; it’s just something you have to be aware of. You have to understand that depending on when you buy, the performance is going to vary.

Mr. Schatz: We have no interest in using them, because in between the first day of the month and the last day of the month, you’re going to lose that pinning of the tracking, and I want my hedge to work exactly how I think. From my seat, these work best in short-term environments. You’ll introduce other problems along the way. The public doesn’t understand right now the tracking for one day. They certainly won’t understand it if we go from daily to weekly to monthly to quarterly to annually.

Mr. Simon: The dust still has to settle, and people should be really careful with these. These are really trading vehicles; they’re not meant to be long-term buy-and-hold. There’s a difference between speculating and investing. I’m not saying they’re bad; I’m just saying they have a very limited specialized use, and it’s buyer beware. You have to be very careful and know what you’re buying. What I do like about them is if, for some reason, we want to put a hedge on them, we can do it very quickly and for a very short-term period. But for the average investor who is trying to diversify his or her portfolio and looking to hedge the risk, there are other ways to do it. There are some of the other non-traditional ETFs that don’t have the structure that an inverse or levered ETF has.

InvestmentNews: What are the mathematics? Can anybody explain it in plain English?

Mr. Simon: Well, it’s the compounding effect, the risk in taking a loss. If you have $100 today and you lose 5%, you’re down to $95. Well, the next day, the ETF has to go up more than 5%. So if you’re in a declining market and you’re in the wrong ETF, you’re getting a compounding negative.

Mr. Schatz: To go a step further, if you just take out an easy Excel spreadsheet and start with a number like 100, you’ll see that the more volatile the instrument gets, the more compounding it has in effect. Because when you lose 10%, if you go from 100 down to 90, and you make 10%, you’re still down a [percentage point] from where you started, because you held it for two days. If you did it day by day, it would be different because you had that full bogey back. You’ll see the more volatile, the longer you hold it, the more it goes awry.

Mr. Schatz: By the way, Rydex [Investments] and [ProShare Advisors LLC] — and, I would think, Direxion [Funds] — when they call on me, which is pretty regularly, they always ask, “Do you want to see the effects of compounding? Do you want to have a discussion about it? Can we educate you more about it?” So I think a lot of people are shooting the messenger. They just provided the product, and they’re getting blamed unfairly because people didn’t read or didn’t open the hood and figure out what was underneath. So go to the providers, get some education, because that’s how you learn the pros and cons of the product.

InvestmentNews: What do’s and don’ts can you give advisers so that they don’t get in trouble?

Mr. Carr: People have been lazy. They think it’s an ETF, it’s an ETF. It’s not this inverse double-down, double-up situation. They didn’t do their due diligence and explain to the clients how the product worked. If there’s some sort of compounding explanation or spreadsheet you can show the client, all the better. Make sure that putting this part of the client’s portfolio in this type of ETF product matches the investment policy statement or similar document that you’re using, especially if you are a discretionary investment adviser. And follow up.

Mr. Schatz: That level of due diligence and really looking at the construction methodology applies not just to the inverse or levered ETF but also to the commodity space. We’ve looked at three different oil ETFs, and they will all three behave very differently, even though the price of oil is quoted every day. How that ETN or ETF is constructed and they way they’re purchasing the futures in the ETF can have a huge impact on just how much tracking error there is between the actual stock price of that commodity and the ETF.

Ms. Moriarty: And this isn’t unique to ETFs either. For instance, if you look in the commodity index area where you’re not necessarily buying anything, you’re just constructing an index for people to follow, you’ll see that they all have to make a decision about when to roll a future as a matter of the rule operating how the index works. And depending how they do that, you can have two indexes based on the same kind of commodity, and they’ll come out with different results because they’ve chosen different ways to deal with the fact that futures expire. If you want something that goes on longer than a futures contract, you have to deal with how you replace the expiring future.

Mr. Simon: To further complicate it, it depends on if the markets are in contango or backwardated. Or depending on how the futures are priced in the marketplace, you can get wildly different results. Contango is when the futures price on a particular commodity is greater on longer-dated futures than on the stock price or the short-term futures. So it’s like a positive, upward-sloping curve. Backwardation is when the stock price, or the today’s price of the commodity, is much higher than the futures that are priced out six months, nine months. So the slope of the futures if it’s in backwardation is like being at the top of a ski hill and going down.

InvestmentNews: Is it perhaps that these products are really just too complicated?

Mr. Schatz: I don’t think they’re too complicated. You can say that about a lot of different products. The bottom line is, they do add more liquidity to the overall system. And that’s healthy. You want more liquidity. I think the education curve is steeper.

Someone asked a question online: “Who’s making money on these, and shouldn’t I be a seller?” My first reaction was to construct a portfolio that only shorted leveraged ETFs and inversed ETFs. I did 1,000 studies on it. It works over time. If you short the two-X long and you short the two-X short, you have a good chance to make money. It’s really tough to sell to a client that you’re going to be short leveraged products forever in a portfolio, but it does work over time more often than not.

And somebody asked about executing ETFs. The liquidity of an ETF is not the volume of it. It’s as liquid as the underlying asset more than anything else, so most of these products are immensely liquid, even though the trading volume’s not there. When you do have wide spreads, depending on what kind of firm you work for, there are other shops out there, besides using a platform where you custody that specifically will help you execute. It seems like there are a lot of answers for ETFs. You have to go a little further than just sitting on your laptop or your desktop and hitting a website.

Ms. Moriarty: One time shortly after the SPDR Gold [Trust] was launched and was such a fabulous success, I got a call from somebody who was in the commodities market — a very savvy guy — and he wanted to create a new fund, and a particular instrument. It was a great idea. And I said, “What’s the liquidity?”” And he said, “It really isn’t very liquid; there are only five or six players in the market.” And I said, “And you’re one of them?” And he said, “Yes.” And I said, “How much of the position do you typically hold?” And he said, “Fifty percent.” And I said, “The SEC is not going to let you create a fund where you hold 50% of the market.” So it never even got to the SEC. So there are some things that do not fit into the ETF mold. It does increase liquidity, but it needs to be liquid before you would even get to that point. So if you’ve got something highly illiquid, an ETF is not a good vehicle. You need to do something else with it.

InvestmentNews: What do you think about active ETFs?

Ms. Moriarty: Well, two things. There is no true active ETF yet. And in order to understand this, you need to know a three-second background on how the ETFs started. Basically, the ETFs are very odd kind of mutual fund. And the reason they’re odd is, they’re only sold NAV once a day or redeemed once a day at NAV by the bid creators. Otherwise, as we all know, their shares are listed and traded at current price, market price in the secondary market.

In order to do that, we had to get a whole lot of permission from the SEC, formally called an exemption order. One of the ways that the commission was willing to give the exemption order was to say, in the case of the [Standard & Poor’s depositary receipts], “It looks as if the trading price of the individual shares will more or less be pretty close to the NAV, because we know what all 500 components of the S&P are, the data are tracked instantaneously, and everybody can follow them. Therefore, it’s transparent, and the [arbitrageurs] can go in when it starts to get out of whack a little bit. So the arb activity will be frequent and voluminous, and it will more or less get the trading price, within exceptions, back. Therefore, you won’t really be discriminating in favor of big people to the detriment of little investors, who if they were mutual fund shareholders would get NAV.”

Now, when you start talking about a true active ETF, active managers don’t want to reveal their portfolios; they don’t want to make them transparent. They grudgingly make them transparent several times a year when the SEC mandates it. But it’s on a backdated basis. They don’t want to reveal their trading strategies. So no one is willing to just go out and do a regular old managed fund and reveal its portfolio every day.

Now, there are certain advisers or managers who are willing to do a transparent managed fund, because in some cases, they don’t mind. Their strategy perhaps isn’t that difficult or odd or they don’t really care if people see it, and those things are what in the trade we call quantified active ETFs. People are buying them.

The real Holy Grail is to do a non-disclosed active managed fund. And there are about six different ideas of how to do this. They have been down at the SEC pending review for about two to three years, and I don’t know how much longer that’s going to take, but there are interesting aspects of each of the six or seven proposals, and problems with each of the six or seven proposals. So it’s very hard to try to figure out who may be the winner or if any will ever succeed. It’s just hard to know.

InvestmentNews: How many of these do we need? And is there anything that you particularly would love to see that you haven’t seen yet?

Mr. Schatz: Frankly, I’m surprised that we have as many ETFs as we do right now. But like anything else, if you build it, will they come? They’ve certainly built too many that address the same thing. And I think, as we started to see in the last year, there’s some consolidation. Fewer and fewer ETFs are coming out, and they’re consolidating. I have a liquidity list that I keep of all these less liquid ETFs. I see a lot of consolidation over the next 12 months, and not a lot of new products.

Is there anything that I want them to build? The answer is yes. I’d like more single countries, and I’d like some commodity ones that maybe behave a little more like my models behave. But we’re waiting for too many issues to be answered by the CFTC first.

Mr. Simon: It’s one of those things where something becomes very popular and mainstream. I do believe ETFs are still in the very early stages of their growth, and they’re going to continue to become a part of the investment landscape. That being said, there are some that I would call flaky or avant-garde out there, and I’m not sure how much demand there really is for those ETFs. But nonetheless, you’re always going to get some of that.

In terms of what I’d like to see, I’d like to see a few more individual countries out there. There are a couple of other asset classes that I’d like to see — I’d like to see an international high-yield fund. Those are a couple things that come to mind. But I would say that even though there’s been a plethora of new ETFs, on balance, many of what have come out have met a lot of investor demand. There are just a few fringe ETFs out there. When you look at it in the big scheme of things, you’re going to have some of that. But I think the trend is still very early on. Given some of the tax advantages, liquidity and transparency that ETFs have over some of their mutual fund counterparts, I just think we’re still what I would call very early on in the ultimate goal for ETF.

Mr. Schatz: In terms of the secondary ETFs that are beginning to come out because of all of our demands for them, the problem is that there are hedging issues. The product may be great, but it may be hard for the people on the other side of the table — the specialists, the creators, the arbs — to properly hedge off risk, which is why you see the ETF not always track the benchmark.

JNK [the Barclays Capital High Yield Bond Fund] is the classic one, and I trade it a lot. But the bonds in JNK don’t always equal the bonds in the benchmark, because they can’t get certain ones that are in the benchmark. And I think that will continue as the more secondary ETFs get traded. They won’t effectively track their index.

Mr. Simon: Yes, you really want to look at tracking error and the underlying index and their ability to actually implement it in terms of being able to get the securities. Because especially in the fixed-income arena, there’s only a finite amount of bonds out there, and being able to attract a certain index gets more complicated as the size of the ETF grows. So you have to pay close attention to these. You can’t just buy it and hold it forever. You really have to monitor the marketplace.

Ms. Moriarty: And also, when you’re constructing the portfolio or managing the portfolio, it’s not like equity. You don’t have limit orders and all kinds of things that you can do with equity. You have to kind of pinpoint exactly what you want. It’s a lot harder.

Mr. Carr: In terms of the expansion of the ETF market, you’ve got to remind everybody out there that they’re fiduciaries to their clients as investment advisers.

And normally, most investment advisers have errors-and-omissions coverage, so I want to just raise the issue. Some errors-and-omission carriers are deeming, or attempting to deem, some of these ETF products as alternative investments and even trying to deny coverage if there’s a claim, or they’re now trying to exclude coverage.

So be very careful about what you’re doing. Document everything. And it might be a good idea to check your errors-and-omissions policy as you move forward with these -products.

InvestmentNews: If an adviser asked proactively, “”Would you cover this?” would they ever say no?

Mr. Carr: First off, you look at the policy. Some policies blatantly exclude certain of the products. Others, you don’t want to approach the carrier; you approach your insurance broker and work with that person to see if you can get a rider or get different coverage, moving forward. That’s what I would recommend.

InvestmentNews: We’ve seen the initial reaction by Finra, which raised concerns about leveraged and inverse ETFs. As we’re getting further away from that initial Finra announcement, and as people have been discussing this more, do you think that concern will continue or be re-evaluated?

Mr. Carr: I think many of the broker-dealers’ in-house counsel and compliance lawyers are re-evaluating things in light of what’s gone down. And maybe there is going to be a slowdown on some of the rollouts of some of these different ETF products. I don’t know.

Ms. Moriarty: You see that the SEC, the CFTC and I guess all the regulators, because of the events of the past two years, have become very conservative and really afraid of their own shadow in some ways. And so they are re-evaluating things that we all thought were settled quite a long time ago.

And I think they are just taking a very conservative position. And I think a lot of the regulated parties are sensitive to that as well and either are being asked to do it by the regulators or are on their own initiative, re-evaluating the same situations because they are afraid of repercussions.

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