In a recent press release, fund manager TCF highlighted the importance of doing “robust due diligence” on passive tracker products like ETFs. Paul Amery, editor of IndexUniverse.eu, asks Gary Mairs, joint-CEO of TCF, what an investor in ETFs needs to know.

IU.eu: Gary, you’ve highlighted the importance for investors of understanding the nature of the index being tracked, with some indices being more opaque than others. Are there some indices that are unsuitable for tracker products like ETFs?

Mairs: You need to avoid excessive concentration, either by industry or individual index component. Many fixed income indices may be insufficiently diversified, for example, as they are typically weighted according to the size of the bond issue, which leads you to invest more in companies with excessive debt.

Also, many investment products are based on proprietary indices, managed by the instrument issuer. It’s arguable whether these are financial indices at all, or just a portfolio which has been packaged, for whatever reason, by the product provider. Here you need to make sure that there isn’t a vested interest in the design of the beta product.

IU.eu: How then should investors approach indices that inherently have no diversification – for example indices based on single commodities?

Mairs: Here the biggest issue is that many indices track futures returns, rather than the spot price, which can produce very different returns to the ones an investor might expect.

It’s also important to examine how commodity tracker products are structured and collateralised – this is probably a bigger issue in commodities than for equity and bond trackers, since the latter are typically managed under UCITS rules, which set minimum standards, whereas commodity trackers can be structured in many different ways, introducing an extra layer of risk.

IU.eu: Some indices generate higher underlying portfolio turnover levels than others, while the resulting transaction costs are not measured in a fund’s total expense ratio. How should investors assess such transaction costs?

Mairs: For swap-based ETFs, such transaction costs shouldn’t matter, since the index return after fees is guaranteed to the fund by the swap counterparty. When a fund is investing directly in the underlying index securities, it’s important to find out from the manager how they minimise transaction costs and which costs are ultimately borne by the fund and its investors. Unfortunately, retail investors can’t get the necessary access to ask those kinds of questions.

Even though such costs are not included in the total expense ratio, it will be possible to identify them after the fact by seeing how much a fund’s performance deviates from that of the index.

IU.eu: How well do you think ETF providers highlight such tracking differences on their websites?

Mairs: I’d say that ETF and index fund providers don’t provide the information that an investor needs to conduct proper due diligence very well at all on their websites. It isn’t that fund providers aren’t prepared to talk about such matters; many are helpful if you ask them the relevant questions directly. It’s more that websites are designed more for promotional rather than due diligence activity, and these are quite complicated topics.

IU.eu: What key bits of information are missing from providers’ websites, in your opinion?

Mairs: For swap-based funds, more information on risk management processes and how funds are collateralised; for directly invested funds, much more information about stock lending; better information on transaction costs and how dealing arrangements are organised; and managers don’t really explain why they are better at tracking than others, while such differences do exist.

Most investors, including quite sophisticated ones, tend to view passive investment vehicles as a commoditised product, but they are not.

IU.eu: Are some swap-based ETF structures better than others?

Mairs: There are differences, but they are not so much differences of approach. They’re more to do with how one assesses the credit risk of the product provider. In extremis, it’s possible that the day a swap-based ETF counterparty like Lehman goes bust is the day when it has put 90% of the UCITS fund in collateral that turns out to be worth significantly less. Let’s imagine you buy a European equity ETF and the next day the product provider and Greece both default, and you discover that your 90% of collateral was invested in Greek government debt. If you compare this kind of event risk with the risk that exists in a physically replicated fund that is involved in stock lending, I’d argue that it’s a risk of a fundamentally different nature.

This doesn’t mean that you shouldn’t use swap-based ETFs, but it means that if you do use them you should be aware of the risks, and you should also be compensated for them by a higher return.

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