Couch Potatoes: Not the Next Financial Time Bomb

I would have been kicked out of journalism school for writing this: “The culprit behind the epidemic of death on our roads is clear: drunk drivers. There are more than 21 million of these in Canada today.” The problem, of course, is that the 21 million figure refers to all drivers, but the context suggest it applies only to the drunk ones.

Now consider these sentences from a recent article by Andrew Ross Sorkin of The New York Times. The article discusses the extreme market volatility we’ve recently experienced and quotes a Wall Street money manager with a theory about its cause: “He says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or ETFs. These funds, which allow investors to bet on a certain basket of stocks, commodities or an index, are perhaps the hottest rage in investing, with some $1 trillion invested.”

Is it clear that the $1 trillion figure relates to all ETFs in the United States, the overwhelming majority of which are plain vanilla index funds? Probably not. It’s likely that most readers will lump in the Sunday drivers with the drunks. That helps explain why so many investors are worried about the coming ETF meltdown.

To confuse matters even further, Sorkin’s article tosses in the line: “You might consider the ETF the new derivative.” What does that even mean? Which ETFs is he referring to? And for that matter, which derivatives, since most of these are plain vanilla, too? It’s an irresponsible statement that preys on the fears of investors who don’t understand complex financial instruments. All they know is that they’re scary, and they should be avoided. CDO, CDS, ETF—they’re all the same. If it has three letters, apparently it must be a financial time bomb.

A few bad apples

For more than a year now, people have been concerned that certain ETF structures could eventually lead to global financial instability. The concerns are legitimate. But they are confined to some very specific products: namely leveraged ETFs, which magnify the possibility of gains and losses, and synthetic ETFs, which use derivatives rather than holding assets directly. These products make up a very small proportion of the ETF industry in North America (although synthetic ETFs are extremely common in Europe).

Let’s be clear: no one is raising these red flags about boring old ETFs that simply buy all of the stocks or bonds in a transparent index. Your Couch Potato portfolio is not going to usher in the next financial Armageddon.

In future posts, I’ll review the concerns about the ETF industry and try to offer Canadian investors some perspective on these issues.

19 Responses to Couch Potatoes: Not the Next Financial Time Bomb

  1. Sean October 17, 2011 at 1:22 pm #

    Money managers cannot compete on price and, in most cases performance, with ETFs. Their personal paychecks are based on assets under management. We shouldn’t expect them to say anything good about ETFs. Everything they do, there is an ETF that can do it better.

  2. Canadian Couch Potato October 17, 2011 at 3:24 pm #

    @Sean: I agree that a lot of the criticism has come from suspect sources. One of the most vocal is the money manager Terry Smith, who has penned a number of articles with ominous titles like ETFs—You Were Warned. He’s argued that ETFs are being “mis-sold” to retail investors who don’t understand them.

    While I’m touched by Mr. Smith’s solicitude, I’d suggest that he direct his advocacy toward the mutual fund industry before worrying about the comparatively tiny number of investors who are sold leveraged or synthetic ETFs inappropriately. Perhaps he can start here in Canada with some commentary about segregated funds, perhaps the most “mis-sold” investment product in this country.

  3. CanadianInvestor October 17, 2011 at 5:03 pm #

    Right you are. Just one ETF in the USA, SPDR’s SPY makes up a big chunk of ETF assets, as does XIU in Canada, both very traditional funds with real holdings of stocks, which makes them no riskier than actually holding the stocks themselves.

  4. Jon Evan October 18, 2011 at 1:22 am #

    “boring old ETFs” Is there anything boring anymore?
    Yes, XIU looks boring enough or should be anyway as you glimpse its purported holdings! But, looking deeper into the ishares prospectus you find disagreeable things like “certain general risk factors inherent to an investment in the iShares Funds”.
    These include the usual culprits: securities lending and derivatives. How risky are these to me an investor I frankly don’t know, but XIU doesn’t look that boring anymore! Just sayin’ :).

  5. Dan Hallett October 18, 2011 at 6:33 am #

    Since you mention leveraged ETFs I thought I’d take the liberty of linking a paper I was paid by BetaPro to write on their controversial products. While the paper is more than two years old, I think it remains a good (albeit long) educational piece.
    http://www.hbpetfs.com/pdf/20090908_dh.pdf

    Many good charts that illustrate the potential downsides of using these products and where they might be beneficial. Shortly after this report was released I heard from a few people who had traded these in the past but, after reading the above linked paper, decided to stop playing with leveraged and inverse ETFs.

  6. Michel October 18, 2011 at 7:00 am #

    Question? If there comes a time where “the bad ETFs” crash and/or collapse from their own doings, won’t the stocks in the good ETFs be seriously affected?

  7. Canadian Couch Potato October 18, 2011 at 9:10 am #

    @Jon Evan: Every mutual fund prospectus sounds scary because they are required by regulators (and rightly so) to disclose anything that might possibly cause loss, however improbable. Take a look at the TD Ultra Short Term Bond Fund, which is pretty stodgy. Investors are warned about credit risk, derivatives risk, foreign currency risk, interest rate risk, international market risk, large investor risk, repurchase and reverse repurchase agreements risk, securities lending risk, and series risk.

    Securities lending, when done prudently, is not particularly risky, and it generates additional returns for the fund. Derivatives may just be futures contracts used to get full market exposure without incurring the expense of buying new shares with the cash generated from dividends, etc.

    @Dan H: Many thanks for providing the link to your report. I remember reading it when it first came out, and it’s an excellent explanation of how these products work. I give credit to Horizons for commissioning it: I haven’t seen any evidence that they are promoting these products inappropriately. They’ve made it pretty clear they’re unsuitable for long-term investors.

    @Michel: I’m not sure anyone knows what the repercussions would be if we had a crisis as a result of something going bad in the ETF world. But sure, the “good ETFs” could still be affected, though they would be the victim, not the cause. And holding individual stocks, or mutual funds, or anything else would not protect you.

  8. DM October 18, 2011 at 9:35 am #

    @ CCP, this is a very timely article and I look forward to the rest of the discussion.
    Maybe you will address this point in a future post but I have been interested lately in “sampling strategies” used by some plain vanilla ETFs. For example, like a lot of couch potatoes, I hold VTI. VTI apparently invests in over “3,000 stocks”. But the prospectus says that VTI only invests in “about 1,200” and uses representative sampling for the remainder. THe good news is that about 95% of the total mkt cap is covered by those 1,200 stocks, but I still wonder why sampling is used. Perhaps it’s impractical for a single ETF to invest directly in > ~1,500 stocks?

  9. Max October 18, 2011 at 10:46 am #

    I that think a market crash is inevitable. “Humanity has reached a fundamental turning point in its economic history. The expansionary trajectory of industrial civilization is colliding with non-negotiable natural limits.” (Richard Heinberg) Things are going to get real hairy real quick.

    I would urge you all to watch “Who Killed Economic Growth”, a short Youtube video commissioned by the Post Carbon Institute, as it illustrates that we have reached a turning point in our current economic system. (http://www.youtube.com/watch?v=EQqDS9wGsxQ) Things, as they stand, are not sustainable. It’s Game Over, folks.

    I once thought that the ‘Couch Potato Way’ made sense, but I want to be able to profit from a collapse, not endure it. I am very interested in certain Proshares Products (namely inverse ETFs such as: SKF, EPV, and SDOW), but this article causes me to question the stability of the ETFs. Would it be safer to short a plain vanilla index?

  10. Canadian Couch Potato October 18, 2011 at 11:06 am #

    @DM: The only risk involved in representative sampling is higher tracking error. As you suggest, funds (especially new or small ones) do it because it is often difficult and expensive to fully replicate an index with a large number of securities, especially if they are illiquid.
    http://canadiancouchpotato.com/2010/04/28/international-tracking-error-part-2/

    The web page for VTI says it currently holds 3318 stocks out of the 3338 in the index. Not sure why the prospectus suggests otherwise:
    https://personal.vanguard.com/us/funds/snapshot?FundId=0970&FundIntExt=INT#hist=tab%3A2

    @Max: I would recommend the “Run to the Hills” portfolio: http://canadiancouchpotato.com/2010/08/08/when-couch-potatoes-go-bad/

  11. Jon Evan October 18, 2011 at 11:18 am #

    I too look forward to your further discussion regarding ETFs.
    Precisely, there are no “boring old ETFs” anymore but in fact all ETFs have turned into complex products from the straightforward assets that they initially appeared.

    You say that “Securities lending, when done prudently, is not particularly risky,” But what the prospectus does not reveal is what collateral is used in the lending and how liquid that is. I’m not aware that there are regulations protecting investors from this counterplay risk ensuring that collateral used in securities lending is in fact prudent. Perhaps you will bring this out in your discussion :).
    What is happening in Europe is bad. For eg. see:
    http://www.fundweb.co.uk/fund-strategy/issues/10th-october-2011/regulators-voice-fears-over-danger-to-retail-investors/1039172.article

  12. NorthernRaven October 18, 2011 at 11:42 am #

    Vanguard’s VTI prospectus reads “The Fund typically holds 1,200–1,300 of the stocks in its target index (covering nearly 95% of the Index’s total market capitalization) and a representative sample of the remaining stocks.” There’s nothing to prevent that “representative sample” from approaching 100%, as it appears to do now, just that the cautious prospectus doesn’t commit them to this.

  13. Canadian Couch Potato October 18, 2011 at 11:45 am #

    @Jon Evan: You raise some excellent points. Fortunately, Canadian regulations require that mutual funds and ETFs accept high-quality collateral (usually government bonds) when lending securities. This is from the prospectus of XIU: “The collateral posted by a securities borrower is required to have an aggregate value of not less than 102% of the market value of the loaned securities… Any cash collateral acquired by an iShares Fund is permitted to be itself invested only in the securities permitted under NI 81-102 that have a remaining term to maturity of no longer than 90 days.”

    As for the extent of securities lending that goes on within a specific fund, you can find this information in the fund’s Management Report of Fund Performance. Last year, XIU earned $157,935 from securities lending. That is 0.00158% of the fund’s assets of $10 billion.

  14. Jon Evan October 18, 2011 at 1:39 pm #

    Thank-you for providing that information regarding Canadian regulations.
    That is interesting regarding XIU! The low % earned from securities lending makes one wonder why bother engaging in that kind of complexity! Why not keep it simple like some etfs that operate as unit investment trusts and are prohibited from that sort of intricacy: http://canadianfinancialdiy.blogspot.com/2010/02/three-etfs-that-have-no-securities.html
    The journalistic fear mongering regarding etfs is not all bad because it’s causing these companies to realize they need to be transparent or investors will get spooked :).
    Maybe I’m warming to some etfs!

  15. Dale October 20, 2011 at 7:01 am #

    Mutual funds are a fraud. Be careful of back end fees as well as the money managers taking your dividends to pay for their pool. I have to transfer my wife’s rrsp to self directed after 19 years at her employer. The AGF money manager recently locked her into fund investments will back end fees. It will cost us over a $1000 to remove her monies. No Canadian should be in mutual funds. Take the time to open and manage a very simple couchpotato style portfolio.

  16. The Wealthy Canadian October 21, 2011 at 9:02 am #

    Thanks for such a superb article Dan. I’ve been reading up on some of the potentially negative effects of ETFs, particularly leveraged and derivative-based ETFs, and I was looking forward to your thoughts regarding the ‘boring’ ETFs that many of us own.

    I had read a recent article on securities lending (to which Jon Evan refers to) and you’ve also cleared some of that up. Thanks

  17. SPBrunner October 21, 2011 at 4:15 pm #

    What I have seen and not cared for when people invest in ETFs, either security or bond, is when they do so because they do not understand the stock market or the bond market. This means that they do not understand the risk they are taking with their money.

    I have seen people very surprised at their ETFs showing losses (you only hear from them when the ETFs go down).

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