Exchange Traded Funds: Read the Fine Print

Unlike earlier blog entries, this one has nothing to do with Flash, audio, or computers.   Instead it’s about another interest of mine: investing.  Today I’ll share some observations about Exchange Traded Funds – specifically that they aren’t as simple or transparent as one might expect.

For many years, I’ve invested in unit trusts (or mutual funds, as they’re known in North America).  Unit trusts typically invest buy shares in many different companies, thus giving diversification and lower risk. Being professionally managed, theoretically they can provide better returns than the average investor would achieve on his own.

Over the years, however, I’ve become disenchanted with actively-managed mutual funds, in part because they seem to perform no better than stock market indices, but mainly because they’re opaque: I have no idea what the managers are buying and selling day to day, and what risks they’re taking.

So amidst the gloom and doom at the end of 2008, I opened an online stock trading account, and have learned and earned buying & selling stock in individual companies, mostly ones traded on the Singapore exchange, but also US and Japanese companies.

To get some diversification, I’ve also used Exchange Traded Funds.  Typically ETFs are set up to track some major stock market index, for example the S&P 500 or the Singapore Straits Times Index.

Recently I’ve become a bit skeptical even of ETFs, as they aren’t quite as simple and transparent as one might think.  Here’s an example: an ETF which is simply supposed to reflect a well-defined index, and which is issued by a reputable firm, in fact comes nowhere close to investing in the index.

The ETF in question is Lyxor MSCI Europe, which I’ve traded recently. The MSCI Europe index is defined by its provider, MSCI Barra, as follows:

The MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. As of June 2007, the MSCI Europe Index consisted of the following 16 developed market country indices: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

The brochure for the Lyxor MSCI Europe fund says it “reflects the evolution of the MSCI Europe [sic]”. In its “Allocation” section, it lists the percentage in various countries (all European) from UK (30.81%) to Ireland (0.44%). Makes sense, but is that what it really does?

A couple of days ago, I received the “Lyxor ETF MSCI Europe Auditor’s Certification” of the “Composition of assets as of 30 July 2010” – a cheaply printed, 12 page A5-sized doc full with densely packed rows of numbers, the sort of thing I’d normally just toss out, especially for an index fund. After all, the composition of the fund will just reflect the index, right?

Wrong. 5% of the fund’s assets are in Japanese companies (in JPY), and 2.5% in US companies (in USD) – companies which as far as I can tell have absolutely nothing to do with the MSCI Europe Index. “All Nippon Airways”, “Yokahama Rubber”, and “Office Depot” are perhaps all fine companies, but what are they doing an MSCI *Europe* fund?

Even the European portion of the fund seems a bit messed up, in that the relative weighting seems to have little to do with the companies’ market capitalizations. German car giant Daimler accounts for a scant 0.01% of the fund, vastly less than other car companies Renault (0.72%), Fiat (0.29%) and Volvo (0.39%). Heck, Daimler’s share of the fund is even less than Yokahama Rubber’s 0.06%.

Possibly the single most puzzling pick “National Oilwell Varco” (NOV), which accounts for 0.60% of the funds assets. It’s one of just four companies in the US Dollar section (the others being Schlumberger, Apple, and Office Depot). According to the sponsored link that appears when you Google the company name, NOV offers a “Full Line of Mobile Well Servicing, Workover and Drilling Rig Solutions”. With a PE of just 11.6, perhaps it’s a good buy, but with a market cap of 18.64B USD it’s not even among the top 50 US companies, and it sure ain’t European.

A friend of mine suggested that perhaps the fine print of the fund’s prospectus allows the managers to be a bit creative with what they can buy.  So I looked it up. According to the Lyxor MSCI Europe prospectus, the fund may purchase:

(i) a basket of shares from countries in the European Community, from all economic sectors and listed on any market or recognised exchange including small capitalisation markets (the “Basket of Stocks”). The shares held as assets by the Fund may comprise of shares that make up the Index (the “Index Securities”) and/or shares comprised within the Basket of Stocks;and

(ii) subject to a limit of 10% of the Fund’s assets (as further described in paragraph 7.6 of this Prospectus), financial derivative instruments negotiated over-the-counter. In particular, the Manager currently intends to enter into swap agreements (the “Swaps”) with a counterparty selected by the Manager. The Swaps would essentially exchange the Fund’s exposure to the Basket of Stocks (or any other financial instruments held as an asset by the Fund) with that of the Benchmark Index.

I don’t see how shares in a company like National Oilwell Varco (or Apple, or Yokohama Rubber) could fit either category.

In short, we have a fund that supposedly just tracks an index (based on what’s stated in both the brochure and the prospectus) but in fact has holdings in companies that appear have nothing to do with that index.

Read the fine print.


About Gerry Beauregard

I'm a Singapore-based Canadian software engineer, inventor, musician, and occasional triathlete. My current work and projects mainly involve audio technology for the web and iOS. I'm the author of AudioStretch, an audio time-stretching/pitch-shifting app for musicians. Past jobs have included writing speech recognition software for Apple, creating automatic video editing software for muvee, and designing ASICs for Nortel. I hold a Bachelor of Applied Science (Electrical Engineering) from Queen's University and a Master of Arts in Electroacoustic Music from Dartmouth College.
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3 Responses to Exchange Traded Funds: Read the Fine Print

  1. Dropped an note to Lyxor, and got the following response:

    Dear Gerry,

    Lyxor ETF is in a mutual fund structure that holds a basket of securities accounted for more than 90% of the fund portfolio and a ELS (Equity-linked swap) for less than 10% of the fund portfolio. The objective of this Lyxor ETF MSCI Europe is to track the MSCI Europe index as closely as possible.

    Until now, in the fund industry, it has developed different ways of index replication techniques: full replication, representative sampling, and synthetic replication. Lyxor adopts synthetic replication methodology that involves the use of derivatives and is the latest technology available for benchmark replication.

    Under synthetic replication, the fund relies on the ELS (Equity-linked swap) to give it the performance of the benchmark index. The performance of the basket of securities is swapped away to the counterparty. As such, the make up of the basket will not affect the performance of the fund. Investor can still receive the Index performance from Lyxor ETF.

    I had attached herewith a FAQ regarding Lyxor ETF and the replication methodology which Lyxor had adopted and its related risk for your reference.

    Hope the above clarify your questions. Please do not hesitate to contact us if any questions.


    Lyxor ETF Team
    Tel: +65 6423-2638

    So there you have it: thanks to synthetic replication and equity-linked swaps, the basket of securities held by the fund has no effect on the fund’s performance!

  2. al says:

    Great post…
    Not too many home investors would have gone thru the composition of assets. You definitely do your research well, gotta give you A+ for effort.

    Also surprising is that you posted since October and no comments. You would have thought that atleast someone would have said thanks for the tip.

    So thanks. Glad I fell into your blog.

    Take care man

    Thanks for the comment. Much appreciated! Didn’t get any comments, but I sure got a lot of views. You’ve inspired me to post more… [GTB]

  3. Pingback: Risks of synthetic ETFs | Gerry Beauregard

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