4. Products that charge dearly for looking simple
Costs 4: Funds, ETFs and products
This module is not about bad products, but about products whose price bears no proportion to what they contribute. The distinction matters because almost all of them have some legitimate use, and confusing 'expensive for you' with 'a swindle' leads you to throw away useful tools and, worse still, to fail to recognize the pattern when it turns up in a different wrapper.
Start with when a fee is expensive, which does not depend on its absolute level but on its relation to what it buys. Paying 1.5% for management that genuinely departs from the index is a legitimate bet that may go wrong. Paying that same 1.5% for a portfolio that is 95% the same as the index is paying 1.5% for 5%.
This way of looking at it recasts the arithmetic of management popularized by John C. Bogle and defended by Burton Malkiel since the nineteen-seventies, and it is the most useful tool in the module: divide the fee by the fraction of the product that does something different from what you would have for a few basis points.
The closet index fund
The work of Martijn Cremers and Antti Petajisto proposed measuring the active part of a fund by comparing its portfolio holding by holding with that of its index. That measure, active share, tells you what percentage of the portfolio would have to be changed to turn it into the index. A fund that replicates the index has an active share close to zero; a genuinely selective fund sits very high.
Out of that comes the notion of the closet index fund: funds sold and charged for as active management whose portfolios barely stray from the benchmark. The research put the threshold of suspicion below 60% of active share and documented that this segment went from marginal to accounting for a substantial share of assets. In Europe, a review by the securities supervisor published in 2016 concluded that an appreciable, though minority, percentage of the funds examined showed signs of that behavior.
How to spot it without expensive tools: compare the fund's ten largest holdings with those of the index, and watch the difference in return month by month over two or three years. If it is always similar and always negative by an amount close to the fee, you have your answer.
Leveraged ETFs: the daily reset
A leveraged ETF promises to multiply the movement of an index by two or by three, but it almost always adds one decisive word: daily. The product readjusts every day so as to hold exactly twice the exposure on the new asset base. That means the result over several days is not twice the index's result over several days, but the product of the leveraged daily returns, which is another thing entirely.
The consequence is called volatility decay, and it works against you in choppy sideways markets.
The round-trip worked in numbers
An index stands at 100. It rises 10% and goes to 110. The next day it falls 9.0909% and returns exactly to 100. After two days, the index has done nothing.
An ETF that doubles the daily movement:
- Day 1: it rises 20%. It goes from 100 to 120.
- Day 2: it falls twice 9.0909%, that is 18.18%. It goes from 120 to 98.18.
The index is flat and you have lost 1.8%. Repeat that swing twenty times and the accumulated loss passes 30% with the index exactly where it started. And that is before counting the cost of financing the leverage or the TER, which in these products is usually a good deal higher than in an ordinary index fund. This is not a manufacturing defect: it is the unavoidable mathematical result of resetting the leverage every day.
Capital guaranteed: the bond and the option
A structured product with a capital guarantee is usually the sum of two pieces. With rates at 3% and a five-year term, guaranteeing 100 euros at maturity costs about 86.3 euros today in a zero-coupon bond. That leaves 13.7 euros to buy options on the index and to pay the fees. If the institution takes 3 euros as its distribution margin, some 10.7 are left for the option, and those 10.7 are what determine how much participation in the rise it can offer you.
Out of that come the three typical features: partial participation in the rise, a cap on the gain and the surrender of dividends, which over five years can come to around 7% or 8% in total. On top of that, the guarantee is a promise from the issuer: if it goes under, the guarantee becomes a claim in the insolvency. And it is nominal, so with inflation at 3% getting 100 euros back in five years' time amounts to getting back around 86 of today's.
None of this is hidden: it is all in the prospectus. What the sales sheet does not do is add it up.
When these products have a legitimate use
Being even-handed here matters:
- A leveraged ETF is a reasonable tool for hedging a position for a few hours or a couple of days, which is exactly the horizon it is built for. The problem is not the product, it is using it as an investment held over time.
- A capital-guaranteed structured product can fit when there is a specific obligation on a specific date and the overriding priority is not to fall short. What you are buying is certainty, and certainty costs money.
- An active fund with a high active share, a restrained fee and a process you can follow is a perfectly defensible bet. What is indefensible is charging an active price for a passive product.
A real case: February 5, 2018
The most instructive case of a complex product badly understood is that of the instruments that bet against volatility. On February 5, 2018 the VIX index shot up in a single session, and a very popular exchange-traded product offering daily inverse exposure to its futures lost around 90% of its value that night. Its issuer wound it up within days.
What matters here is that the prospectus contemplated that ending explicitly: a large enough daily move could take the value practically to zero. The product did what its documentation said it would. The complexity was not hiding a fault, it was hiding a reading: those who bought it had seen years of excellent returns and never divided them by the risk that generated them.