Passive funds to buy and hold, and those to watch like a hawk

We name the types of index funds and ETFs that require minimal maintenance, and explain why care needs to be taken with the more exotic strategies. 

Exchange-traded funds (ETFs) are meant to be straightforward. They track the performance of a given market index, so there is no need to worry about trying to pick the fund that will outperform. They come with remarkably low charges – just a handful of basis points in the cheapest cases. And they’re listed on recognised stock markets, so you’ll always be able to get in and out of the fund quickly and easily.

So far so good, but there’s a problem. The simplicity and transparency of ETFs have proved so popular with investors that fund managers have been tempted into coming up with ever more clever wheezes to grab their share of the market. And in the process, they have introduced complexity and opacity.

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The result, warns Dimitar Boyadzhiev, a senior analyst for manager research at investment analyst Morningstar, is that ETF investors who think they’re getting a simple product they can buy and hold for the long term may actually be getting something very different.

“The marketing of these products is challenging,” Boyadzhiev warns. “You may well not want to be in them for long.”

Regulators are growing concerned about this issue. In May, in the US, the world’s most-evolved ETF market, the Financial Industry Regulatory Authority (Finra) issued a call for feedback on ETF sales practices for “complex products” following a surge in trading of these funds by US retail investors.

“The number of accounts trading in complex products and options has increased significantly in recent years,” Finra said. “Investors may not fully understand the attendant risks”.

In the UK, meanwhile, the Financial Conduct Authority (FCA) has recognised that the ETF market can be a place where marketing bravado can sometimes trump investor protection. For example, it is currently refusing to authorise ETFs offering exposure to the cryptocurrency market.

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Where, then, does the greatest risk in the ETF market lie? Well, the most fundamental question of all may be whether you want to be in passive funds at all right now.

“The market environment has greatly changed recently and looks very favourable for active managers going forward,” argues Dzmitry Lipski, head of funds research at interactive investor. “Truly active, high-conviction managers who are more pragmatic, and style agnostic in their approaches have the opportunity to outperform given current volatility and dispersion in market leadership and valuations.”

The three buckets index funds and ETFs fall into

1) Plain vanilla

Food for thought – but many investors will still want passive funds for at least some parts of their portfolio. In which case, Morningstar’s Boyadzhiev argues that broadly speaking, you can divide passive investing into three buckets. First, there are the original plain vanilla ETFs or index funds that track indices such as the FTSE 100 or the S&P 500.

These are simple vehicles that often serve as the bedrock of investors’ portfolios, Boyadzhiev points out, offering a cheap way to secure exposure to core stock markets.

“Generally speaking, these are reasonable buy and hold funds,” he adds. “The only caveat to that is that if you’re aiming for a particular asset allocation, you will need to rebalance your investments in these ETFs from time to time, because as each market performs differently, you’ll move away from your starting target.”

Still, assuming your investment objectives don’t change, that might mean checking in with these funds as infrequently as once a year. By contrast, Boyadzhiev’s second group of ETFs will require more frequent attention.

2) Exotic strategies

These are more exotic funds, where the manager seeks to deliver a more sophisticated type of return. Into that group you would certainly include leveraged ETFs, which use derivatives contracts and debt to amplify the performance of the markets in which they invest. That’s great in a rising market, but losses are amplified when markets fall too, exposing investors to significant risk. They therefore have to be monitored closely.

Thematic ETFs are another potential area of concern. These funds aim to give investors exposure to long-term investment themes deemed likely to deliver outsized returns – anything from the rise of the middle classes in Asia to the growth of e-commerce in retail. “The problem with these funds is they are very often narrowly invested in one sector of the market or one geography,” Boyadzhiev warns.

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Smart beta funds – and other variations on the ETF theme that offer a more active management style – could also be a worry. The performance of these funds is more exposed to the judgement of the manager standing behind them, which leaves greater room for doubt.

In part, of course, these are subjective judgements. Tom Bailey, head of research at specialist ETF firm HANetf, points out that you could make a case for thematic funds as the ultimate buy and hold investments. “They are meant to tap into those really long-term structural changes, so they have to be regarded as long-term holdings,” he argues. “Still, they are bets on the future, and the future is uncertain, so they do need to be watched.”

3) Multi-asset passive approaches

Equally, extra complexity doesn’t always mean additional risk. In Boyadzhiev’s third bucket are index funds such as Vanguard LifeStrategy and BlackRock MyMap. The launch of these vehicles moved the passive market on from the plain vanilla funds in that they’re multi-asset passive funds; you choose the fund that offers the asset allocation best aligned to your investment objectives and attitude to risk.

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The advantage of that approach is that you don’t even have to worry about periodically rebalancing your allocation, since the fund does this job for you – if you’ve opted for an ETF that offers 80% exposure to equities and 20% exposure to fixed-income, that’s where you’ll stay.

In theory, that makes such funds even more low maintenance than the simpler vehicles, although you will want to remain confident your investment objectives have not changed.

Buyer beware

The bottom line is that with so much choice now on offer for passive strategies, it is imperative that you understand exactly what you’re buying. If every fund was a simple product offering straightforward exposure to a clearly defined set of assets, there would not be room for the thousands of fund launches that the market has seen over the past two decades.

Due diligence is therefore crucial – and even some simple checks should alert investors to the dangers. The key information documents issued by leveraged ETF providers, for example, make it clear these products are designed with shorter-term time horizons in mind.

More broadly, an unpredictable change in the market backdrop can have a fundamental effect on an index fund or ETF, warns HANetf’s Tom Bailey.

“Regulatory ETFs are a good example,” he says. “There’s a lot of investor interest on a global scale in funds offering exposure to the move towards the legalisation of medicinal cannabis in many countries, and in funds focused on deregulation in the gaming and gambling sector, but governments can and do change their minds very quickly.”

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Finally, remember that it’s not just where ETFs invest that matters, but how they do it.

“Physical ETFs should be fairly straightforward but synthetic ETFs introduce an additional element of counterparty risk,” warns Scott Gallacher, a director of independent financial adviser Rowley Turton.

The distinction, as Gallacher explains, is that while physical ETFs buy exposure to the assets they’re supposed to be tracking, synthetic ETFs mirror performance through the derivatives market. “There is then the risk that the swap issuer defaults,” he points out.

In recent times, Gallacher concedes, counterparty risk has not proved especially problematic, but it represents a danger that investors may not have anticipated – and are unlikely to be monitoring for. This is a potential problem that may sneak up on you unexpectedly.

Indeed, this may not be the moment to be too clever, warns interactive investor’s Lipski. He says: “Overall, I think that we are moving towards back-to-basics investing, meaning more challenging times for some esoteric, thematic, leveraged ETFs given their style biases towards fashionable themes.

“Simple, easy-to-understand strategies with a focus on capital protection rather than shooting the lights out may be preferable.”