SINGAPORE (June 4): Investors should be aware of the risks when it comes to investing in exchange-traded funds (ETFs) and notes (ETNs), especially those that track derivative products, say industry experts.

Jackie Choy, Morningstar director of ETF research in Asia, says this is the crucial lesson from the US market correction in February, when the ­VelocityShares Daily Inverse VIX Short-Term ETN (XIV) plunged more than 80% in a single day and was subsequently liquidated. The XIV provided returns when the markets were calm as it provided the opposite returns of the CBOE Volatility Index.

As a result, many investors suffered massive losses when the US market’s volatility spiked due to investor concerns about the higher-than-expected inflation rate. At the time, the Dow Jones Industrial Average dropped as much as 10% while the financial markets globally were mostly in the red.

Lars Kroijer, former hedge fund manager and author of Investing Demystified: How to Invest without Speculation and Sleepless Nights, says in the early days, most ETFs were index-tracking products. But today, many of them deal with derivatives, which are associated with high risks.

“Thus, it is important for investors to know that buying into ETFs is not buying into index-tracking funds anymore. You could end up buying into derivatives that you do not fully understand,” he says.

The XIV is a good example. ­Kroijer expects that most individual investors did not understand how the fund worked and the risks associated with it. “I would say that less than 1% of the people who buy into the XIV could walk through the methodology on how [the index] is constructed,” he says.

“Retail investors who are not sophisticated enough should not be investing in derivatives and speculating on market volatility. It is not where they should be putting their savings. If they find themselves buying into inverse volatility with their savings, they are not doing the right thing.”

At a time when investors have easier access to ETFs listed in various countries and regions, they should educate themselves before investing in these products, says Kroijer.

Julian Ng, a financial consultant and former fund manager, holds a similar view. He says investors, regardless of whether they are active or passive, should understand the products they are buying into and the risks involved.

Ng, a proponent of passive investing who is in the process of applying for a licence to launch a robo-advisory platform, believes that most local investors are not investing according to their risk appetite. He says it is entirely possible that they may take on excessive investment risk when inverse and leveraged ETFs and ETNs become readily available in the country.

“I dare say that most investors in Malaysia are not investing according to the risk they are willing to take. They are like betting their houses on red in roulette without knowing why,” he says.

Choy says investors should understand the products they are buying into when investing in passive funds. “There are plain-vanilla ETFs that track index movements. There are more complicated ones such as inverse ETFs that generate returns based on the opposite direction of an index. There are also leveraged ETFs, which amplify the returns and losses when an index goes up or down, and ETFs that are both inverse and leveraged.”

Choy says investors who read the fund prospectus more carefully will be able to understand the risks they are taking on and also the conditions under which the fund will be liquidated.

Should these products be regulated?

The introduction of ETFs has provided easier and cheaper access to asset classes in various sectors and regions. A key reason is the low minimum investment amount.

In the Malaysian context, the market price of the FBM KLCI ETF was RM1.94 as at May 23. So, an investor who wanted to buy 100 lots would only need to fork out RM194.

The same applies to some of the inverse and leveraged ETFs listed on the New York Stock Exchange. For instance, a quick check on Bloomberg shows that the ProShares Short VIX Short-Term Futures ETF — an inverse volatility ETF similar to the XIV — had an NAV per share of US$13.33 on May 21. Meanwhile, the Samsung KODEX Leverage ETF (Equity-Derivatives FoF), which tracks the performance of the KOSPI200 Leveraged Index, has an NAV per share of about KRW16,555, which is relatively affordable.

Kroijer says this creates the risk of retail investors buying into high-risk derivative products that they do not fully understand. So, should the authorities regulate these products and only allow sophisticated investors to trade in ETFs?

Kroijer says this could be an option. But investors should also educate themselves on the different investment products and instruments and know their financial goals.

“It goes both ways. Investors can’t always expect the regulators to protect them from their own mistakes. On the regulators’ side, it is also not easy for them to regulate the creation of all these products that are being pushed out into the market,” he says.

“At the same time, it is good for the market to have greater access to different products. So, it is a challenging task for the regulators to strike a fine balance. There is no simple answer to this.”

Choy says regulators in different countries take on different approaches. In general, the regulators’ task is to safeguard investors’ rights, such as ensuring the fund providers disclose sufficient product information. On the other hand, investors should take on the responsibility of educating themselves. “They must do their homework,” he points out.

Kuek Ser Kwang Zhe is a senior ­writer with The Edge Malaysia

This article appears in Issue No. 833 of The Edge Singapore which is on sale this week. Or subscribe here so you won't miss an issue.

Could derivatives-based ETFs cause next crash?

Lars Kroijer, former hedge fund manager and author of Investing Demystified: How to Invest without Speculation and Sleepless Nights, says exchange-traded funds (ETFs) could cause the next market crash if more derivative-based products are introduced to the public without controls.

“I certainly think this kind of product can cause problems down the road. You are allowing people to gain exposure to high-risk products that they don’t fully understand. Sometimes, when people get greedy, things can go wrong very quickly,” he says.

“Today, ETF providers are putting all sorts of things into the funds. People may think that it is just tracking an index, but it is not that simple,” he adds.

The US market correction in February, which subsequently caused the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) to be liquidated, has drawn criticism from market players. Besides the concerns about derivative products deceptively wrapped in the form of an ETF, market players say these passive investing instruments tend to buy into big-cap stocks (on an index or alternative index) blindly, regardless of their fundamentals and earnings when the market is on a bull trend.

When the markets plunge, ETF prices could fall dramatically as money flows out of the markets. If this happens, market volatility could increase.

There are also concerns that when passive investing dominates a large part of the markets (mainly via index-tracking ETFs), trading activities and market liquidity could reduce dramatically. This could cause capital misallocation and market mispricing. Big-cap stocks, for instance, could be overvalued owing to demand from new ETFs that track market indices rather than from improving fundamentals.

Jackie Choy, Morningstar director of ETF research in Asia, says ETFs do not have a “direct impact” on capital misallocation and market mispricing. He adds that the ETF market size and trading volume still trail behind those of actively managed funds.

“Some investors may think that when passive investing gets too big, it could cause such a problem. But we are not even near that threshold,” says Choy.

Jack Bogle, founder of the Vanguard Group, said last year that the ETF industry may make up 45% of the mutual fund industry in the next five years and that it could reach 75% without posing much risk to the market. For now, the US ETF industry is about 20% to 25% of the mutual fund industry, says Choy.

He says the managers of actively managed funds should be able to move into the market for some bargain hunting should the market mispricing happen due to a panic sell-off. “Theoretically, this is where the equilibrium comes in,” he adds.

Julian Ng, a financial consultant and former fund manager, concurs. “I know these arguments. But I don’t think an ETF-driven resource misallocation has a huge impact on the market now because active investors are still very dominant.

“Also, when market mispricing happens, profit-seeking ETF providers can fix the situation, which means new ETFs can be created to take advantage of any misallocation.”

He also believes that the regulators will take necessary action if the ETFs grow too big and become unhealthy for the market.

Kroijer says ETFs are just an investment product. The underlying holdings of the ETFs and investor behaviour determine whether issues are created in the market.

“Market players point fingers everywhere when the market crashes. But an ETF is just an instrument. It is not correct to say an ETF could cause the market to crash,” he says.

Choy says the size of the ETF industry is expected to continue growing as it remains an attractive avenue for low-cost investments.

Ng points out that there are several benefits to holding ETFs. “They are structured very cheaply. Some of these well-structured products with high liquidity have very few hidden costs. Also, you can get instant global diversification at a low cost.”

Kroijer agrees. “ETFs are still a good investment tool for general investors as long as they invest in what they understand and stay far away from what they don’t,” he says.