In the News: ETF investors rock the boat

Exchange-traded funds are popular with investors because they allow them freedom to hop in and out of any market to lock in gains.

The story of exchange-traded funds (ETFs) is a story of invention. It's about how the financial markets worked out a new way of packaging an investment and then updating it as new possibilities emerged.

About 10 to 15 years ago, all the rage in investment circles was the "core-satellite" theory. What this meant was that an investor's portfolio would be made up of a core of shares and possibly a raft of bonds, while the satellite would be an index fund tracking the main stocks of a selected market.

The index fund would "hover" over the core shares to ensure that the investor not only picked excellent stocks and bonds, but also received the benefits of that market's momentum as a whole.

It was the perfect mix of your own active stock selection, and the passive moves of an index you had no control over.

It was, many thought, a no-brainer. People rushed in until the stockmarkets tanked. Heavy losses were sustained during the tech wreck of the early 2000s and the indices plunged. It wasn't the fault of the investor; that's what so many of them were being recommended.

Into the breach came the ETF - a kind of hybrid idea combining active and passive investment. It had all the momentum-based qualities of an index fund, but now the investor had a semblance of control over it. You could buy and sell them like a share. ETFs surged in popularity.

These products have since become the biggest single collective investment vehicle in the world. At their most basic level, the ETF is simply a listed index fund that aims to match the performance of major benchmarks, such as the S&P 500, the Dow Jones or even the Abu Dhabi Securities Exchange.

Nowadays, they can be used to bet on the price of commodities, such as copper, oil and grains, through funds that can be bought and sold as easily as shares.

The kinds of ETFs now coming onto the market are innovative to say the least.

Global providers, such as Blackrock and Powershares (run by Deutsche Bank), offer ETFs that track the resource commodities (oil, gold, silver and copper), the major currencies and soft commodities including soya beans and corn.

You can even have an ETF that tracks a whole basket of commodities, say a raft of different agricultural products. PIMCO, a global specialist in bond funds, has recently launched the PIMCO Australia Bond index fund to capitalise on Australia's export of commodities and its role as a major trading partner with emerging economies in Asia.

It will follow this up with the PIMCO Canada Bond Index Fund and the PIMCO Germany Bond Index Fund because it believes the product will replicate the strong management and good returns from these markets.

What this means, of course, is that investors can now buy and sell favoured countries, commodities and sectors in the same way as they would do a local bank or a mining company.

The world literally becomes the investor's oyster - and any parts they decide to discard they can do so with the flick of a button. Another no-brainer? Well, it's not as simple as it sounds.

First the good news. One of the large global providers of ETFs, S&P Indices, says that in the US - and in most other global markets - ETFs that track the main share indices produce above average performances.

In the US, for example, about three out of every five actively managed funds don't beat their benchmark indices.

David Blitzer, the managing director of S&P Indices, says his company's numbers show that in the past five years in the US, only 38 per cent of active managers had beaten the S&P 500 and the S&P 1200, the very indices the ETFs were tracking.

And the bad news? When markets are volatile, as they have been in the past six months, ETFs have been viewed as the main culprits behind the big intra-day fluctuations that have been rife in just about every market. Some blamed the leveraging of ETFs - that is, huge amounts of money used to borrow to invest into the vehicles, which can be releveraged and deleveraged in seconds.

ETFs are particularly attractive to investors because they can bet long or short - and they can borrow huge amounts to do so. There's nothing to stop investors investing in any market they wish, hopping in and out of the investment to lock in gains.

There are ETFs that are "inverse leveraged", which act in a seesaw manner. They go down in value when the market goes up and vice versa. Because these vehicles are also leveraged, the gains and losses are magnified.

However, Mr Blitzer says much of the problems are not the ETFs fault. "What the ETF does … is to make it inexpensive to trade a block of stocks," he says.

In other words, its facility to buy and sell is not the problem; the problem is the greed and fear of the traders. It's a bit like blaming the man behind the gun, not the gun itself.

It is worth knowing what kind of ETF you are investing in. The traditional ETFs (known as physical-replicating ETFs) hold the underlying securities in an investment (that is, whatever the index, they invested directly and in proportion to it), but some are synthetic.

That means they contract with a third party. In exchange for a fee, the third party agrees to provide index returns to the ETF vehicle using derivatives. There is the problem that the counterparties to the deal, as they are known, could become bankrupt, default or simply not meet its obligations. In Europe, many of the ETFs on offer are synthetic - in the US it is a small proportion, as it is in the Asia-Pacific region.

And then there are those commodity ETFs. These are backed by futures contracts, not by the physical assets they track. What this means is that you may not be getting quite what you think you're getting. That is, the ETF may not move in the same way as the physical asset. The price of oil, say, could rise, but the ETF may fall in value.

An example would be an ETF that tracks a basket of agricultural products. It will track an index that measures the returns on soft commodities, such soya beans or corn. Future contracts will be used to generate gains because the ETF cannot physically store the grain or beans, or whatever the commodity it is tracking.

Each contract has to be rolled over before expiry, which may be about three months after purchase. The upshot is that it is possible that those buying the commodities are forced to roll over contracts for an ETF and buy more expensive ones, incurring a possible loss for the investor.

And so again, ETFs are evolving. To stop this from happening, a number of giant players are setting up funds that actually store the assets themselves. ETF Securities in the UK has produced funds that physically hold the copper, aluminium and other industrial metals.

BlackRock, the parent firm behind iShares, the world's biggest ETF provider, and JP Morgan are also looking at truly copper-backed ETFs.

ETFs, like any other product, are not as straightforward as they may seem. Like any other product there are risks to be considered. The point is to be wary, as with all investment products and make sure the investment is transparent.

Keep it simple is probably the best option. Do not invest in synthetic vehicles and be careful when investing in commodities ETFs. It is not just about understanding the commodities, but understanding the antics of the futures markets in which these kinds of vehicles trade.