Technical note on ETFs

I’ve often said that I am a terrible stock picker.  I don’t believe in stock picking, for every good pick there is the equivalent terrible selection.  What makes a good stock trader is not his ability to pick winners, but to have the guts to “cut-out” the losers quickly, and I am crap at that part of the equation!

Anyway, my favorite stock investment instruments are ETF – Exchange Traded Funds that allow me to take position in virtually any global strategy (did very well for a while investing in Taiwanese stocks as a proxy for China).  Funny enough the first ever ETFs were invented in Canada – really, but the real big ones are the QQQQ, spiders etc that provide access to some of the biggest stock plays in the world (in the case of the above two:  Nasdaq top 100 stocks and the S&P500).  The reason I like ETFs is that since I am a terrible stock picker (alpha) the way I make money in the stock market is following the trend of the market in general (beta).  The other attractive feature of ETF is that they are easy to buy have very lower management fees (most) and brokerage fees are minimal as they can easily be bought using a discount brokerage account.

Anyway, being somewhat involved in the financial market I kind of know how ETFs are made, especially I know how they are made in Canada – most of the ETFs are made by the book runner buying and selling the underlying stocks – that way the ETF tracks the index (more or less).  However, to reduce the tracking errors (because different stocks have different volatility coefficients -- it gets complicated here) derivatives are used here.  That way if you buy the ETF for the S&P/TSX 60 your tracking error may be as small as 25/35 bps (1/3 of 1%).  However, in Canada there are liquidity issues (Canada is a small market) about 10-12% of any specific ETF assets will be derivatives (instead of the underlying stock).  In the U.S. where liquidity is much higher (and we are talking orders of magnitude here!) maybe 5% of each ETF is made up of derivatives – and for the really big ones (QQQQ & SPY) it is probably lower (less then 1%).

In Europe the proportion of derivatives is much higher.  Primarily for fiscal efficiency it is efficient to use derivatives instead of the underlying equities; as much as 50% of the average ETF is made up of derivatives.  The issue with derivatives is counterparty credit risk.  Not only is there a risk vis-à-vis the sponsor but also towards his own derivative counterparty.  Moreover, whereas the sponsor of the ETF in North America is usually an independent firm (free to replace the book runner) in Europe the Sponsor and the book runner are one in the same.

I’m not saying that investors should avoid European ETFs, but I wonder how many investors realize that whey the buy the ETF for the CAC40 they are in fact taking a great deal of European bank risk, with virtually no recourse to the assets of these firms (they become an unsecured creditor).  Anyway it gives everyone something to ponder on this Thursday morning.