Additional uncertainty

Embedded-strategy ETFs (ESETFs) have proliferated in recent years as the traditional passive ETF product space has become saturated.

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Passive ETFs follow capitalization-weighted indices (except those based on the Dow Jones index, which are price-weighted), hold physical assets and offer proven, low-cost exposure to various asset classes. ESETFs bring new promises and a new set of challenges.

Unlike passive ETFs, ESETFs encompass a broad range of strategies that could be classified by investment strategy (other than a cap-weighted index) and by aspects of implementation (use of derivatives). The table “Types of embedded-strategy ETFs” (this page) shows some examples.

Risks arising from embedded strategies come in many forms. Often these risks are unfamiliar to mainstream investors. In Q4 2008, investors overlooked the volatility sensitivity of leveraged ETFs, mistaking the daily rebalancing target for a long-term performance promise.

Unprecedented volatility punished both bull and bear ETF performance levels. So in order to use them successfully in portfolios, advisors must understand the risks inherent to ESETFs.

Active risk

For investors looking to build portfolios with stable risk profiles, active risk adds variables such as manager discretion, lower transparency (particularly in Canada) and higher tracking error. All of these factors contribute to additional uncertainty and obstruct the portfolio risk-management process.

Liquidity risk

ESETFs tend to have lower trading volumes, with the notable exception of leveraged ETFs (which are used primarily by active traders and constitute approximately two-thirds of the overall ETF trading volume in Canada).

Lower liquidity for the remaining embedded-strategy universe means bid-ask spreads can be fairly wide.

Market makers providing a liquid market for those ETFs have to hedge their positions. The lack of liquid hedging instruments results in basis risk that market makers pass on to investors with wider bid-ask spreads.

Risks arising from embedded strategies come in many forms. Often these risks are unfamiliar to mainstream investors."

Volatility drag risk

Volatility risk takes on a whole new meaning with leveraged ETFs. Investors understand higher volatility generally means higher loss potential.

For leveraged ETFs, the negative impact of volatility is more deterministic — in turbulent markets the performance of a daily rebalanced leveraged ETF suffers due to volatility drag.

Mathematically, this is expressed as the difference between the arithmetic, or daily rebalanced, return and the geometric, or end-of-period, return. The latter is relevant to the investor as it represents money in the account at the end of the investing time horizon.

Transparency issues

ETFs are famous for their transparency, compared with other managed-money products. This is particularly true of passive ETFs. In Canada, however, many embedded-strategy ETFs take advantage of the less stringent regulatory environment. Compared with the U.S., where ETF manufacturers are required to disclose complete holdings daily, in Canada, manufacturers need only disclose their top 25 holdings quarterly and full holdings annually.

Manufacturers argue less transparency benefits investors by helping to protect against front-running. The downside is investors who manage portfolio risk would find it hard to make accurate estimates when holdings are unknown.

Credit risk

Some ETFs use over-the-counter derivatives such as forwards and swaps to gain exposure to the underlying securities (e.g. Horizons BetaPro COMEX® Copper Bear Plus ETF (HKD)) or to create a tax-advantaged structure (e.g. iShares Global Monthly Advantaged Dividend ETF (CYH)).

These derivatives are subject to counterparty credit risk and can influence the market value of the ETF assets if the credit quality of the forward or swap issuer deteriorates significantly.

Roll risk

Commodity ETFs, unless they invest in the physical asset, such as the iShares Gold Trust (IGT), are subject to roll risk. Roll risk occurs when the spot price of an asset differs from the futures price, resulting in contango or backwardation. Some commodity products, such as PowerShares DB Gold Double Long ETN (DGU), attempt to optimize roll yield.

Investing with ESETFs can provide new portfolio construction opportunities and give access to an array of diversifying asset classes. They also come with new risks of which investors should be aware. From the daily challenge of assessing active risk and liquidity costs, to the dormant credit risk and volatility drag, investors need to look at the additional sources of uncertainty when investing with embedded-strategy ETFs.

Ioulia Tretiakova is vice president and director of Quantitative Strategies at PUR Investing

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