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The Enlightened Investor: Investment Industry Corruption

The Enlightened Investor: Investment Industry Corruption

Reading the title you probably thought of ponzi schemes or advisor malfeasance in the form of ‘borrowing client money’ or ‘churning accounts to rack up trading fees’. Yes, there are a few bad apples in the investment industry but that is not what I mean.


I am referring to when the investment industry corrupts a good idea for its own selfish purposes. Such as fund companies who market every possible version of a good idea to unsuspecting often ill-informed investors in order to attract assets to manage.


Consider the industry’s attempt to capitalize on the trend towards Exchange Traded Funds (ETF’s). In their purest form these stock like issues represent a basket of securities much like a mutual fund. Unlike a mutual fund, broad-market ETF’s have many advantages including significantly lower management expenses and holdings that match the diversified market benchmark portfolio. These types of passive index ETF’s earn the market return and take market risk as opposed to active mutual funds that rely on manager research to pick a smaller number of securities, which are unlikely to outperform the market return, and will undoubtedly take more risk and expense in trying.


For instance, the Ishares Core S&P 500 Index ETF holds a broad market portfolio of 506 US stocks. These stocks are specifically meant to mirror the holdings of the S&P 500, a benchmark of 500 US stocks. But, how many of these broad-market, low-cost index ETF’s do we need? How would a fund company differentiate their offering in order to entice investors to invest in their ETF’s?


I’ll answer that for you. They brainstorm every possible variation on the good idea and build a convincing story to excite investors. Thus, we have a proliferation of manufactured ETF variations with all the bells and whistles, tricks and gimmicks you could ask for.


Perhaps I could interest you in the Horizons Beta Pro S&P 500 VIX Short-Term Futures Daily Inverse ETF? Would you be more interested if you knew this ETF lost 88% of its value between February 2 and February 6th, 2018 due to market volatility and that Horizons ultimately terminated this fund?


A broad market index ETF earns market returns and takes market risk. The Horizons ETF promised the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index. According to Horizons an unexpected level of volatility in after-hours markets impaired the trading of the underlying derivatives that provides the inverse exposure to the S&P 500 VIX Short-Term Futures. Safety and simplicity be damned!


I’ll bet losing 90% of your investment overnight wasn’t part of the fund companies pitch to investors. I wonder how many of the sell-side advisors understood how this derivative based security worked? Or, how well were the risks of this particularly complex ETF described to and comprehended by investors?


And so there is a cautionary tale for all investors. Just because the investment industry can dream it up, manufacture it and sell it to you it doesn’t mean its good. If you want variety, if you are interested in the latest flavour of the day – stick to ice cream. Your downside is limited to a few dollars and a bad taste in your mouth. When it comes to investing your retirement savings, choose simple vanilla securities that are easier to understand don’t expose you to risks you can’t even fathom.


Chris Turnbull CFA, CFP, TEP, is an independent Portfolio Manager at the Index House, specializing in passive index portfolio management.