Well he would, wouldn’t he?

When Mandy Rice-Davies was giving evidence at the trial of Stephen Ward, charged with living off the immoral earnings of Keeler and Rice-Davies, in the Profumo Affair, she made a famous riposte. When the prosecuting counsel pointed out that Lord Astor denied an affair or having even met her, she replied, "Well, he would, wouldn't he?" (often misquoted as "Well he would say that, wouldn't he?"). By 1979 this phrase had entered the third edition of the Oxford Dictionary of Quotations.

I was reminded of this by the attack on my views on Exchange Traded Funds (“ETFs”) by Alan Miller who runs SCM Private, a fund management business which uses ETFs as its sole form of investment. He clearly has a vested interest in persuading investors that concerns about ETFs are exaggerated.

You might think that I also have a vested interest in this matter as I run an active fund. Not so, I would suggest.

Firstly, anyone who has attended any of my presentations will know that when asked I have always said that most of the time investors would do better purchasing a low cost widely-based index tracking fund than the sort of active fund which mostly have been offered to them. One of the key problems with ETFs is that many investors believe they are being sold such index trackers when clearly many of them are not:

a) I have already provided evidence of how you can lose money on a leveraged long ETF when the relevant index goes up over a period when it is volatile and its rise is punctuated by sharp falls, and similarly you can lose money in a short EFT over a period when the relevant index goes down over a volatile period punctuated by sharp rallies. Hardly what one would expect from an index fund; and

b) Note the phrase ‘widely-based’. When an investor is being sold or has his or her funds put into an ETF which is long Turkish equities, short Shanghai A shares, long Emerging Market bonds or short Natural Gas this is not the same as buying an index fund or a plain vanilla ETF based on the MSCI or the FTSE100. It is an active fund management decision, with risks which are totally different to the purchase of an index fund, and no amount of fast-talking can disguise that fact.

Some of the concerns I have voiced about ETFs have been echoed by, amongst others, the Financial Stability Board, the FSA, the International Monetary Fund, the Bank for International Settlements, the Deputy Governor of the Bank of England, and the Lombard column of the Financial Times (“Raciest ETFs are an accident waiting to happen” Financial Times, 25 May 2011). But what do they all know compared with Mr Miller?

Let’s take a look at some of the points he makes in defence of ETFs and some of the criticism he makes of my own equity fund under the guise of defending ETFs as an investment tool.

1. Shorting ETFs

To start with he dismisses my concern that as ETFs are tradable they are often used by hedge funds and investment banks who short them to hedge or speculate on certain risks and that the short interest can become a multiple of the size of the ETF with dangerous consequences. He draws an analogy with shorting an individual company share, pointing out that ‘for someone to short a share requires someone on the other side to buy it’. This reveals an apparent lack of understanding of the difference between an ordinary company share and an ETF.

Because a short seller in an ETF can rely upon the ability to create units in the ETF, the short interest can become multiples of the size of the ETF, a situation which should not be possible in an ordinary company with a fixed share capital, only part of which will be available to borrow so that short sellers can deliver stock to fulfill their short sale.

The risks involved in the short selling of ETFs were well described in a White Paper “Can an ETF Collapse” by Brendan Connor, CFA, Director of Research, Hillview Capital Advisors, LLC; Andrew Bogan, Ph.D; and Elizabeth Bogan, Ph.D:-

While ETFs often appear to be a benign innovation as compared to some of Wall Street’s arcane derivatives, a closer look at the mechanics of short selling ETFs (which have become one of the most prevalent securities to short) raises some serious concerns. While an ETF owner believes their ETF shares represent ownership of the underlying shares of stock in the index that the ETF tracks, that stock is not always all there. Because of explosive short interest in some ETFs, owners of ETF shares often far outnumber the actual ownership of the underlying index equities by the ETF operator. One might ask how that can be possible, but the creation and redemption mechanisms inherent to ETFs mean that short sellers need not be concerned about the availability of shares outstanding when they sell an ETF short—since they can always create new shares using creation units to cover short positions in ETFs in the future. In essence, there appears to be little risk to being short an ETF since the short seller can always “create to cover”. This has led to some ETFs having shockingly large short interest as compared to their number of shares outstanding and for every additional ETF share sold short, there is another owner of that share.

Take the SPDR S&P Retail ETF (NYSE: XRT) as an example. The number of shares short was nearly 95 million at the end of June, while the shares outstanding of the ETF were just 17 million. The ETF was over 500% net short! Or to look at it from another perspective, the ETF’s operator, State Street Global Advisors, believed that there were 17 million shares of the SPDR S&P Retail ETF in existence and owned shares in the S&P Retail Index portfolio to underlie those 17 million ETF shares. But, in the marketplace there were another 95 million shares of the ETF owned by investors who had purchased them (unknowingly) from short sellers. 78 million of those ETF shares were serial short—that is they had been borrowed and re-sold more than once—or they were naked short (not borrowed at all). The short sellers had promised their prime brokers to create those non-existent shares (above and beyond 100% of the shares outstanding) if necessary to cover their short in the future. In both cases the share buyer, however, is completely unaware his ETF shares were purchased from a short-seller and no doubt assumes the underlying assets in the index are being held by the ETF operator on his behalf, but no such underlying stock is actually held by anyone. Clearly this creates a serious counterparty risk and quite possibly the potential for a run on an ETF—where the assets held by the fund operator could become insufficient to meet redemptions.

Even more alarming was the recent rate of redemptions from the SPDR S&P Retail ETF in July and August 2010. Redemptions occur when more owners wish to sell out of their holding in the ETF than there are new buyers for the existing shares, so unwanted blocks of 50,000 ETF shares each are redeemed through the authorized participants with the ETF operator for cash, or more typically for in-kind shares in the ETF’s underlying index’s stocks. The SDPR S&P Retail ETF was one of the fastest contracting ETFs in July due to redemptions and as of July 31, it had just 7 million shares outstanding. However, the short interest was little changed—still over 80 million shares short. Suddenly, 11 times the number of shares outstanding was short, which is even more worrisome than 5 times back in June. By late August, the shares outstanding in XRT had dipped briefly below 5 million shares with 80 million shares still short (16 times the shares outstanding). Mercifully, net buying interest has rebounded somewhat for the SDPR S&P Retail ETF with the improving outlook for retailers and shares outstanding in XRT had rebounded to 12 million by mid-September. But if the rate of contraction last month had continued, the ETF was just days away from running out of underlying stock altogether.

So what happens if the recent monthly redemption rates return and 15 million more shares in the ETF were redeemed by the end of this month? Presumably the SPDR S&P Retail ETF might simply close and cease to exist once its remaining 12 million ETF shares outstanding had been redeemed and all its underlying equity holdings had been delivered to redeeming authorized participants. But where does that leave all the ETF owners who unknowingly bought their shares in the ETF from short sellers? If the ETF is all out of underlying equities and is essentially shut down, what happens to the remaining owners of the 80 million shares of the ETF? The ETF operator would have no more underlying shares (or cash) in the fund and the ETF would have essentially collapsed since all the shares outstanding were already redeemed. At recent prices the unfunded remaining ownership in the marketplace for which nobody currently owns any shares would be over $3 billion for just this one ETF! Extend this hidden unfunded liability from massive scale short-selling of ETFs (both traditional and serial) across the entire ETF spectrum and it is a $100 billion potential problem.

I wonder if Mr Miller could enlighten us as to how this is the same as shorting shares in Collins Stewart plc or any other public company and why this does not represent a risk?

2. ETF transparency

Mr Miller makes great play of the apparent transparency of ETFs: “ETFs publish the underlying holdings of the indices they follow daily and nowadays most [note not all] ETFs also publish daily a full list of their collateral where applicable.” He contrasts this with mutual funds, such as my own, which do not publish a list of all their holdings.

In another statement quoted in a Financial Times article “ETF providers attack systemic risk warnings” on 17 April 2001 Mr Miller is quoted as saying “Look at Deutsche Bank for example. If you drill down [on its website] on its synthetic ETFs, you can see exactly what the collateral is and who is the provider.” (Emphasis added).

This raises a number of issues which he fails to address. Should individual investors be investing in synthetic ETFs which do not hold assets in the indices they are expected to track but swaps which are designed to match that performance? The very fact that you have to ‘drill down’ to find out what collateral is held suggests that investors in funds which invest in ETFs or who invest directly may have little or no idea what risks are being run and what is really in their ETFs. We have seen time and time again that disclosure in the small print or where you have to ‘drill down’ on a website or in an offering memorandum to establish what you really own is used more as a device to camouflage risks rather than to inform investors. Investors in products such as CDOs, CLOs, CDOs Squared and other complex and toxic products which foundered in the Credit Crisis could have found out more about these products if they had drilled down. But the very need to drill is a warning signal in itself.

Contrast this with owning a mutual fund that owns ordinary shares in Nestle, Procter & Gamble and Unilever. You don’t need to do much drilling in them to understand what you own.

As for mutual fund disclosure, as well as the top 10 holdings which Mr Miller acknowledges we have disclosed, Fundsmith has also disclosed the top five contributors and detractors to our year end performance. In total this has provided disclosure of 16 of our total of 23 holdings, representing some 80% of the portfolio. Given the low turnover on our portfolio, this does not change much. All of our holdings are in ordinary shares, we have no derivatives, hedges or short sales. Our definition of our ideal investor is one who understands what we are trying to achieve and our methodology so that they can have the emotional discipline to stay with us through the inevitable ups and downs of market and economic cycles and reap the benefits of the long term compounding of the wonderful returns that these companies can provide.

The issues presented by synthetic ETFs, short ETFs and leveraged ETFs with daily rebalancing and shorting EFTs make the headline in SCM’s brochure “Exchange Traded Funds (ETF) Simplicity, Transparency and Diversification” risible.

3. Fees

Mr Miller tries to make the case that investment in ETFs is low cost and much lower cost than my own mutual fund. He compares the charges on the Deutsche Bank MSCI ETF with my own fund’s Total Expense Ratio which he estimates at a range of 1.15% to 1.75% - I would agree with an estimate of 1.25% for the T Class shares.

However, as I am sure he well knows, this is a deliberate attempt to compare apples and pears to suit his own case.

If you own ETFs through Mr Miller’s SCM Private Absolute Return Fund you will also pay his charges which are 0.75% p.a. plus 5% of any annual gain.

In SCM’s brochure Mr Miller quotes a Financial Times article “The charges laid against us” that uses an example I have also used. It shows that Warren Buffett achieved an annual compound return of some 20% p.a. for the 45 years 1965-2009. He achieved this in his investment vehicle Berkshire Hathaway in which you can co-invest alongside him. If you had invested $1,000 in 1965 your stake would have been worth some $4.4m 45 years later. If however, Berkshire Hathaway was a hedge fund and Mr Buffett charged the standard 2% p.a. of assets and 20% of annual gains, and had invested his fees alongside you in the fund, of that $4.4m, $4m would belong to him as manager and your final stake would be worth just $400,000. Clearly this fee structure is unsupportable.

The attached spreadsheet shows that if you invested the required minimum of £250,000 in SCM’s Absolute Return Portfolio and achieved the rate of return of 7.6% p.a.* which it achieved in the year to March 2011, over the same timescale as the Warren Buffett example, 45 years, this would become worth £12m. But this is before fees. If SCM’s 0.75% p.a. and 5% performance fee are deducted, your final stake would be reduced to £6.6m and he would have gained £4.4m (adjusted for VAT) on an initial investment of zero since his holding is built on the fees charged to you. ETFs may be low cost investments. ETFs owned via vehicles such as SCM aren’t.

* SCM performance and fees: All the performances quoted appear to be after fees.  SCM fees are 0.75% plus VAT (management) and 5% plus VAT of any gain (performance).  With VAT at 20%, this equates to a management fee for the individual (who cannot reclaim VAT) of 0.90% and 6% of any gain.

Adjusting the net performance of 7.6% for fees, the gross performance can be calculated to be 8.99%.  The net 7.6% would imply a performance fee plus VAT of 0.49% which, together with the management charge plus VAT of 0.9%, gives total fees paid (including VAT) of 1.39%.  The calculation is shown on the attached spreadsheet. 

 

Comments

[David Jordan]

Hi Terry,

Why have the income units outperformed the accumulation units according to the fact sheets? I would have thought it would be the other way round (unless reinvestment transaction fees exceeded the amount to be reinvested, which surely would negate the point in reinvesting!)

I'm probably missing something as I don't know for certain how unit trusts work, I'm just assuming they work how I think they do - please advise!

[Terry Smith]

As the fund is new and we have yet to pay a dividend, you would expect the Inc and Acc Classes to be equal in price, but there are rounding differences of 1bp which do occur from time to time due essentially to the rate of expense accruals and the differing size of Classes. Once we pay a dividend, the Income shares will be markedly different from the Accrual shares and David Jordan is right, the Inc Class will have the lower price.

[David Jordan]

Thanks Terry - bit unorthodox asking here maybe but it made sense at the time as both an avid reader of your blog and a fundsmith investor. Keep on thinking!

[Nick Thompson]

Good to see that this week's Economist (pp 89-90) has picked up the ETF story.