When ETFs are far too 'clever' for your own good

As passive investments that represent an underlying index, exchange traded funds (ETFs) are great. Access to the passive replication of something that would be very hard for individual investors to do alone is a real service. Where they go wrong is when an issuer creates an "active" ETF because of some fad-like and often momentary demand for one particular investment theme.

The most obvious ones to me are some of the capital-destroying income-focused ETFs that make unrealistic promises about beating the market yield. Many of them add no value to the total return and make up that extra income by effectively returning your capital to you while pretending they have some miraculous income-generating formula that simply doesn't exist.

ETF providers are not shonks and charlatans; in a world of hyper-disclosure, they are not hiding anything, bamboozling anyone, or being "bad" fund managers.

Any ETF does exactly what it says on the box and the performance will always be in line with logic, based on the structure of the fund. Where you will go wrong is to simply believe the marketing without reading the detail, which is clear as day if you bother to look for it.

"Action" has its cost 

In the income ETFs there is no way of genuinely delivering higher than average equity yields without money being lifted from somewhere else, so what are they doing? Get reading. Odds are you will quickly come to understand that there is no genius, there is a process, and the outcome is predictable.

In any active ETF there is a cost of "action": the transaction costs, the spread costs, the management costs of buying and selling stocks. An ETF that isn't passive costs more to run.

And that's before we come to synthetic ETFs, or ETFs that include some hedging or derivatives. They all nibble away at the total return. Derivatives cost money. Hedging costs money. Spending money on options to reduce volatility, for instance, costs money; options cost money.

Then, of course, there are the fees for management of the fund, and the more active, or less passive, the fund, the more the management costs are going to be. Take off those costs of activity and active ETFs are never going to achieve an average return, let alone an above-average return without some genius or luck, and that's not why most people come to ETFs.

The point is that you have to separate active ETFs from passive ETFs, and if you invest in active, or "clever", ETFs you have to read beyond the marketing to the detail.

Ask these questions

The requirements in a product disclosure statement (PDS) mean all ETF products are very upfront, honest, even if the structure is flawed and the marketing line emphasised above the detail. It's all there for you to read, but you do have to read it to understand what you're getting into. Anyone promising you something for nothing has got their fingers crossed behind their back.

So ask yourself with every ETF: is this plain vanilla, or has this been created for marketing purposes, or because there is a demand for it in the middle of a fad?

An easy filter is to ask whether the ETF has some discretionary/active/non-passive element to it. Look at whether its construction is straightforward.

Does it represent physical assets like gold, for instance, or is it synthetic, created out of or including some smarty pants options or futures positions that are designed to somehow replicate the real thing or hedge something or make something safer (which usually does the opposite).

Does it use derivatives? Whenever a fund uses options or futures, those contracts cost money. They detract constantly from the return, and over the years can do vastly more damage than they do good for investors.

And does it use leverage? You can write a lot of fabulous marketing lines about leveraged products using examples of when it goes in the right direction. But when it doesn't? They don't write about that.

In the end, there are ETFs and then there are ETFs. The ETFs that very efficiently, at low cost, without any bells and whistles, replicate something like an index, without brains, without active management, coming from a major issuer, can be easily understood, trusted and invested in.

It's not hard to spot the safe ones; just make sure you go past the first page of the marketing document.

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