Access To Any Market: At What Cost?

We talk a lot about what good investment vehicles exchange traded products are. How their low costs and ability to trade intraday make them an attractive product for both retail and institutional investors alike. Their other characteristics, such as being able to access any market, also make them attractive tools for investors, but it would be remiss of us to not look further into this and really establish what impact 'accessing any market' has.

A lot is made out of cost – that is the Total Expense Ratio (TER) of the ETP, but there are also some other costs that might impact your returns such as tracking error and tracking difference. Yes, they are two different things and the impacts they have on your ETP are also different.

Tracking error is how effectively the ETP is tracking its benchmark (underlying index).

Tracking Difference is the actual difference between a product's return and that of its benchmark over a specific time period.

For example, the RBS Market Access MSCI Emerging and Frontier Africa ex South Africa ETF (M9SZ) hasn't had a brilliant two years. In fact, its tracking difference has been off by 14 percent (see chart below). But according to a spokesperson from RBS, there is definitely no issue with the (ETF) exchange traded fund.

Graph: Bloomberg

Another ETF which underperformed last year was the db X-trackers CSI300 Health Care UCITS ETF, which underperformed last year by 3.88 percent, while the db X-trackers Frontier Market ETF underperformed its benchmark by 1.68 percent.

On speaking with one market participant, they said that emerging market ETPs have high tracking difference in general because you have to consider the fee of the product, plus the transaction costs to access that market. There are also swap adjustment fees that are levied as a result of the hedging cost.

But worst of all, the iPath VIX Short-Term Futures ETN (VXIS), which tracks the S&P 500 VIX Short-Term Futures Index Total Return, is also down 97 percent on last year – ouch! (See the graph below)

Graph: Bloomberg

So, what is happening here?

Well, all these ETFs have something in common: they don't track blue-chip indexes. Tracking niche markets is a tricky business and this is why the ETFs that do track these markets are traditionally synthetic (swap-backed) – it can become very costly when you start buying all the securities from the index.

Liquidity in niche markets

Ben Seagar-Scott, senior research analyst at BestInvest explains that the cost of a swap can be high if you are trying to access niche areas. "From the bank's point of view they need to hedge it so trading in a less liquid market uses different hedging techniques and that can reflect in the NAV. It is easy for mainstream indices but for niche indices to implement a swap it is more expensive."

When you physically track a niche market it means you have to buy up all the stocks separately. It becomes costly and in order to lower costs and boost tracking providers often 'optimise' the stocks, so while you get better cost you sacrifice some performance. "While this helps with price it means you will sacrifice some accuracy and there will always be pockets of cost difference as a result," said Seagar-Scott.

He adds that ETFs work with large blue chip indexes. "But they can also give the illusion of liquidity but the underlying is less liquid in niche areas."

"What synthetic ETFs do is shift the liquidity risk exposure away. This will happen increasingly as use of ETFs is likely to grow as we get into more niche markets. Liquidity risk is a problem in physical ETFs. With synthetic ETFs you swap the counterparty for liquidity risk – so it becomes the bank's problem (so long as the bank doesn't go bust), but in physical ETFs then the investor is exposed to liquidity risk – so, what happens if there are redemptions all at once?," he asks.

However, all the above ETPs use a swap to gain access and their tracking is still off. So, are they really the better product?

Contango

Adam Laird, passive investment manager at Hargreaves Lansdown explains that the performance of the VIX ETN (exchange traded note) is a result of contango, meaning the future price of the product is higher than the expected spot price, resulting in a sell low, buy high situation.

Laird said: "The VIX index is down 16 percent from where it was in May 2010, the iPath ETN is down 97 percent! This is a very heavy contango product."

Laird does explain that the performance of these products can and does deviate significantly from the underlying index and the products have been used successfully by experienced investors. "It's just imperative that you know what you are buying."

Optimisation - does it work?

Seagar-Scott also adds that physical replication not only has a higher TER but also high tracking error in niche markets.

The LSE-listed iShares MSCI Emerging Markets Equity ETF is a good example of this, its tracking difference off by 0.67 percent in the last year (mid-2013 to July 2014).

Until the middle of last year its tracking difference was down by 2 percent – the physical ETF was optimised, meaning certain stocks were selected from the index and this was because some of 23 countries in the index were not available, such as India, Russia, Chile and Colombia.

However, since the middle of last year this ETF has had access to all local markets in the MSCI Emerging Markets index and therefore now tracks more accurately, coming down to 0.67 percent in the last year.

Peter Sleep, senior portfolio manager at 7IM, said: "So much for getting perfect tracking with swap based ETFs."

Sleep also points out that one fund with "good" tracking difference is the iShares Emerging Markets Asia Local Govt Capped bond, which beat the index by 0.54 percent in the year due to the sampling techniques employed. The iShares Emerging Markets Small Cap ETF  also used the provider's sampling technique and outperformed.

So, is this a technique that genuinely works or did the ETF just get lucky?

Regardless of this solution, Seagar-Scott debates that trading difference is good to shine a light on, because it is ultimately a cost to the end investor.