When is a duck not a duck?

26th April 2013

If it looks like a duck, it walks like a duck and it quacks like a duck, then logic suggests it must be a duck.  If you apply this simple test to index funds, it could end up costing you a lot of money. For although most investors believe that these passive investments provide a transparent, low cost return on a stated market index – and it may be so of some early index and exchange traded funds - it is not necessarily true for new generation products.

In a low interest rate environment, the actions of central banks have forced investors to seek higher returns in riskier asset classes. An increasing percentage of this money flow has been captured by passive investments, particularly Exchange Traded Funds, with investors aiming for low cost market returns. According to BlackRock, the providers of iShares, there is US$2.04 trillion invested in ETFs around the world, with US$387 billion invested in Europe. With rapid growth in the last five years, new entrants have been tempted into the ETF market, some focusing initially on price to gain market share and then innovation. However, product development has created increasingly complex ETFs, also a willingness to venture into less liquid markets where trading costs are sometimes less transparent.

Institutional and professional investor demand has led to ETF products being created beyond developed and emerging market indices. Today, there are fixed interest, property, commodity, currency and other alternative ETFs to construct part or all of a multi asset portfolio. Furthermore, actively managed ETF offerings have been introduced.  These are a far cry from the original concept of index less fees. This is a result of the inconclusive debate on active versus passive investment, with many institutional and professional investors preferring a blend of each approach.

New generation ETF products require considerable expertise to understand what exactly is going on under the bonnet. That’s not to say they are not worth looking at, merely that closer examination is required,less so for the traditional ETFs which continue to be refined with more efficient tracking methods and reducing fees. These are market timing investments and treated by many investors as core portfolio holdings. It is these products - designed for active investors seeking to add value from tactical asset allocation, or style and sector rotation - that require more analysis. Typically these investments support a portfolio strategy such as risk reduction, enhanced income or alternative capital growth potential. These specialist strategies can often be cyclical and as such will underperform at points in the investment cycle.

The development of both the ETF and index fund market, particularly with the likes of Vanguard entering the market, is most welcome. However, aside from the traditional index products, there is concern that less sophisticated investors will be attracted to increasingly complex ETFs.  Less transparent products may contain hidden fees and charges. Be warned, when a duck is not a duck, it may be a cuckoo come to spoil a nest egg.