Risks in ETFs

What’s culturally popular can host hazards to health and wealth.  ETFs (exchange traded funds) can be an example.  Not unlike popular drugs of the 1960s which promised greater “highs” yet brought devastating “lows” the damage for some can be irreversible.  Best counsel for recreational drugs was to avoid them;  counsel for ETFs is to be fully aware of their structure and risks.

ETFs (and ETN cousins) have grown immensely in size and number since 1980.  It’s become amazingly popular in newspapers and websites to promote ETFs as a low-cost investment.  But where is the honest evaluation of long term risks?  Safer than LSD for sure! …but if you haven’t examined the real history and how ETFs may torpedo your nest egg then pause before buying.  Carefully examine the impact on your financial planning.

Definition in the words of Investopedia:  “An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange.”   That’s a fair start and to learn more here is a link:  http://www.investopedia.com/terms/e/etf.asp.

“THE ALMOST-PERFECT ETF” ???

May 21, 2015,  The Globe and Mail (HERE) heralded “The Almost-Perfect ETF”.  The title implies there have been problems in the ETF universe.  Indeed there are concerns that affect not just ETFs but human behavior involved in how people use them.

The ETF closest to perfection is said to be the Vanguard Total Stock Market (VTI-N) …which “has always provided dirt-cheap access to the full breadth and depth of the U.S. stock market”.  Furthermore it boasts that this ETF is now “returning the exact same amount as the stock index it’s based on.”  This is intended to come across as terrific news!

Reviewing actual results of this “perfect ETF” can be illuminating.  A public chart here shows the history since VTI opened Jan 2001.  Capital growth in this 14 year period has averaged 2½% and to that you’d add near 1.7% dividend, bringing total return to about 4% ….or near 2% after-inflation (then minus tax)Risk is another thing: when world markets fell in 2008, the peak to trough in this fund was minus 57 1/2%.  The picture below shows where the ETF at $78.26 on Oct. 8, 2007 dropped to $33.26 in March 2, 2009.  That’s a long drop, but you really cannot criticize a fund for dropping like this when its very “mandate” was to follow the market.  Obviously when markets are down, this fund is going to follow along very closely, down, down, down.  Fortunately it also recovers, so at April 2, 2013 the ETF again reached $78.26.  Net change in the ETF from Oct/07 to Apr/13 was zero …which in my books is a very very long time to wait for recovery …especially as we have other approaches which fall less and recover sooner (see LIM below).

Pic _ VIT ETF

Certainly one can say that this ETF should reflect a wide investment market while containing costs.  The unadvised person who owns units of this ETF however is taking responsibility on themselves to know when to sell out of this security due to an impending storm hitting investment markets.  This ETF offers no security against the storm, except to ride it out and hope that someday there will be a full recovery so some growth can resume.

REVIEWING THE RISKS.

News media and popular magazines make it sound cool to invest in ETFs because they reduce some risks of buying individual stocks, and reduce costs compared to many retail mutual funds.  Such ideas are now heavily promoted in various papers and websites.  Clearly ETF firms want to attract more investments.  But seldom is given the caution of what can go wrong.  Here's are some areas to consider ...

100% Market Risk.  As in the VTI graph above, it will be true of other ETFs that as they follow the market up, they’ll follow their market benchmark down as well – some more, some less.  If you’re aiming to reduce the nightmare of extensive multi-year losses, then other strategies could be more comfortable.  Possibly the initials LIM (below) could point the way to an approach with safeguards to help conserve wealth when markets are hit badly.

Cost are higher than they seem.  ETFs are pretty cheap if you buy once and hold forever.  Two groups of people pay much more.  Younger people investing each month would generally pay commissions every time they buy ETF units.  Older people selling units for monthly income would similarly be forced to pay commissions each time they sell.  If you thought ETFs were “free” you want the bigger picture.

More on Real costs.   VTI above proved initial and ongoing costs that are as close to FREE as one can get, until you consider actual investment risks, precipitous losses, and waiting for recovery.  In 14 years VTI gave near 4% total-returns, but with devastating losses amid that journey!   A managed and sustained approach for income and growth may involve higher management costs …but is that really a cost if we may cut losses by half or better?  Imagine if you could repeat 2008 with portfolio (a) or (b) -- you choose!  (a) zero costs with 57% drop and 5.5 years to recovery,  (b) 2% costs, 15% drop, and 18 months to recovery.  (See LIM.)  Which plan feels better?  ...for you?  ...for your parents?  ...for life-income and family-estate?

Psychology and human behaviour.   The greatest risk wasn’t the first time one tried a joint, but when it became a habit or other drugs became more enticing.   Behaviour also changes when people own ETFs.  (1) ETFs are often NOT held for the longterm but people buy and sell them with ease, perhaps as short-term positions until they see another shiny idea, causing commissions and costs to arise.  (2) ETF investing can lead to a tempting array of other ETFs that increase risks and even leverage (multiply) risks exponentially.  The lure of more exotic ETF products such as bull or bear ETFs can steal wealth quickly and permanently:  even after the benchmark index breaks-even your own account can show a severe and permanent loss.

Avoiding a Bullet.  As memory serves, year 2000 opened with Nortel at 35% of the Canadian market so index funds and related ETFs would have to carry Nortel at 35%.  A troubling history at a Canadian bank illustrates three times shooting itself embarrassingly in the foot over recent years -- and you might have chosen to avoid that bank -- but an index ETF can be forced to hold the very stock that makes you hold your nose.  And if your conscience is uneasy with companies that promote tobacco, gambling, and environmental tragedy then ETFs may give you a rash.

Timing and re-balancing your portfolio.  Do investors ever get nervous?   Do markets ever turn sour?  Social media and other news will scream that the sky is falling.  How long will you keep your discipline – stay true to a long term certified plan – amid the barrage of woe from TV, radio, and daily papers ...raising blood pressure with fear and indecision!   The investor caves in after a few weeks, perhaps a month or two, selling out to wait until things look safe again.  But when media announce things are safe, markets have already recovered half or more!  (Indeed exuberance is a better indicator of risk, while fear may mark opportunity!)  So how would you manage portfolio strategies to match your wealth and financial goals?

Lacking professional guidance.  Yes you can buy professional planning with an ETF portfolio.  But investors buy ETFs for the lure of low costs.  Buying an advisor can cost 1% to 1.5% of assets.  If Jane Doe invests in ETFs and then buys advice on top, costs can easily reach 1.5% to 2% …plus HST.  So that's the ballpark we offer with actively managed funds and certified financial & estate planning.  Don't let a lure of low costs sabotage the financial and estate planning you need to guard your future and your loved ones.

Complexity.   The universe of ETFs now exceeds 1,000 and is growing daily.  Pic _ ETF ShortsSome ETFs specialize in unique sectors (and heightened risks).  Many hardly trade at all (forcing costs of illiquidity).  Many are too small and will end up closed or merged into something else.  More surprising are synthetic ETFs that don’t even hold the securities you’d assume they own.  And if you buy an ETF you don’t know if you’re getting the real thing or if you’ve bought a short-sale from another party who’s betting that fund is going down!   Some ETFs have been “shorted” so strongly that there can be 200%, 300%, 400% more virtual units on the market than what the firm has actually issued.  You’d never know.   (Sample chart …sorry it’s dated.)

Voices of caution.  ETFs are used for various good reasons.  But if you’re hearing only the positive spin, then also consider from June 2012 Financial Advisor magazine on this subject: If you’re looking to buy a long-term buy-and-hold portfolio, the vast majority of (ETFs) are not appropriate for you. Included in the ETF line-up are a number of very sophisticated, very risky securities.  If used correctly, they can be very powerful tools.  But if used incorrectly – or by investors who don’t fully understand their mechanics – the results can be disastrous.

A few Questions to consider and discuss:

  1. ”Am I ok having my investments passively follow an index, or would I rather a professional advisor help reach my objectives?”
  2. ”Do I want to be in charge of managing investment risks, or would I prefer an advisory team do that for me?”
  3. ”Do I have time and expertise to design my portfolio, or would I prefer less stress with professional care?”
  4. ”What are the real costs?  Is it better to reduce downside risks to get a safer journey for life?”
  5. "If a perfect investment existed, what would it look like?"

LIM = LIFE INCOME MANDATES?

I’ve given considerable focus over the years to sharing types of assets that support strong growth & life-income with reduced risk.   These strategies would be successful in any decade of the last 200 years, with profitable results.  In my book “A Lifetime of Wealth – And How Not To Lose It” and in my educational website “GuaranteedIncome4Life” I share key principles of “Life Income Mandates” (LIM).  How you actually implement such a portfolio will depend on the laws where you live, how your invest, and what professional support you have available.  Suffice it to say, LIM focuses on global assets combining income and growth from dividends, real estate, infrastructure, and fixed-income …in a model to be uniquely designed to your personal needs, goals, and loved ones.  See further in STICKY MONEY and freely explore the links to sustaining growth and life-income.

NET RISK-ADJUSTED RETURNS FOR LIFE.

A terrible fallacy today promotes buying something because it’s cheap.  Would you buy a car that way and trust your family’s safety?  Would you buy a home that’s cheap, and worry at night that faulty wiring may cause a fire?   For investing too, cost is a factor, but lowest-cost is a mirage that can steal wealth and make you wait 6+ years to get it back (if you're prepared to be that patient).  It's been proven.  The answer isn’t just low-cost.  The real answer to focus on is, “net risk-adjusted returns for life” ...designed specifically to ensure your money can STICK TO YOU.

Brian Weatherdon,  MA. CFP. CLU. CPCA. CRC. MDRT. 
627 Guelph Line, Burlington, Ontario. L7R 3M7.   905-637-3500 x 223. 
Ret.Coach SEALCertified Financial Planner.  Certified Retirement Coach.
brian@SovereignWealth.ca 
Amazon: “A Lifetime Of Wealth — And How Not To Lose It.”
"STICKY MONEY"introducing "Life Income Mandates".

 

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