Some ETFs belong in the ETF graveyard. They’re portfolio poison.
I’m going to tell you about two. And this isn’t a story of the market that they invest in (more on that in a moment). But instead, it’s the story of a terrible investment product.
Most of the time, ETFs do what you expect them to: They copy the movement of an index.
Except when they don’t – and a good market is spoiled by a bad way of investing in it.
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Great market… awful returns. Why?
Finding a good market it tough. Lots of markets, and stocks, decline.
But Vietnam is a great place to invest. It’s one of Asia’s fastest-growing economies.
After nearly a dozen years of GDP growth averaging 6.2 percent a year (the U.S. saw 1.6 percent during that period), the country is booming.
Trade between the U.S. and Vietnam has also been growing nonstop.
Overall, Vietnam stocks have been on a roll – at least as measured by the Vietnam Index, which tracks the 376 largest stocks listed on Vietnam’s two stock exchanges. Since early 2009, the Vietnam Index is up 235 percent.
So if you’d decided to invest in Vietnam back then in the most obvious and easy way – an ETF – you might think you’d be sitting on big gains now. ETFs generally move in line with the index they’re investing in.
But the two “Vietnam ETFs” have done a terrible job of tracking the Vietnamese market. Since early 2009, the VanEck Vectors Vietnam ETF (New York Stock Exchange; ticker: VNM), has dropped 21.3 percent and the db X-trackers FTSE Vietnam UCITS ETF (London Stock Exchange; ticker: XFVT) has dropped 3.7 percent.
That’s not just underperforming the index by a few percentage points. That’s awful performance that actually lost investors money – by investing in a market that was up more than 200 percent over the period.
Since the beginning of 2016, the story is a bit better. Both of these ETFs underperformed the index by a large margin – but at least they were up. Since 2016, the Vietnam Index is up 83 percent, while VNM (which has US$415 million in assets) is 21 percent, and XFVT (which has around US$300 million in assets) is up 51 percent.
The abysmal performance of these ETFs – compared to the market they claim to track – highlights the enormous cost to investors of ETFs failing to meet their stated objectives.
This is what ETFs should do
In 2005, there were 500 exchange-traded products (ETPs), most of which were ETFs, that had US$400 million in assets. Today, there are more than 8,000 – with US$5.4 trillion in assets under management.
ETFs are an easy and convenient way to buy a sector, index or strategy via a single, exchange-traded investment. For instance, if you only have a small amount of money (relative to other investors), it’s nearly impossible (and expensive) to buy all the individual stocks in the S&P 500. But by buying shares of SPY (State Street’s SPDR S&P 500 ETF), an investor can do just that – cheaply and easily.
However – as the Vietnam ETFs show – just because an ETF claims to track a given market, doesn’t mean it accomplishes what it promises. The difference in performance – the shortfall between an index’s performance and the ETF that tracks that index – is called tracking error.
One big source of tracking error is that sometimes an ETF doesn’t own all the securities in the index it’s supposed to replicate.
You’d think that to replicate an underlying index, ETFs would buy each index component in a proportion equal to its weighting in the benchmark. Some ETFs use this “full replication” strategy.
But others employ “sampling” techniques. That’s when they construct a portfolio that is similar to the index – but actually holds a different mix of securities.
This is where the Vietnam ETFs get into trouble.
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Vietnam’s unique tracking error
In Vietnam, the government – via State Operated Enterprises (SOEs) – still owns large stakes in many publicly-traded companies. As a result, the number of shares actually available for trading – which is called the free float – can be tiny for many stocks. For some of the biggest companies on the Ho Chi Minh Exchange, less than 5 percent of outstanding shares freely trade.
This makes shares of companies very illiquid (that is, they don’t trade much) and volatile. That’s a big problem for an ETF manager who is trying to buy and sell millions of dollars’ worth of shares to replicate an index.
The structure of the Vietnam Index makes tracking Vietnamese markets problematic. It’s a market cap-weighted index, which means that the weightings of stocks in the index are based on a stock’s market value (share price times the total number of shares). To accurately track the index, an ETF manager would have to regularly rebalance its holdings, as market caps change.
For instance, if a thinly traded stock rises quickly in value, a manager tracking the index would have to buy more shares to maintain the proper weighting in the index. However, if shares available for purchase are limited because of state ownership or other float restrictions, then rebalancing an ETF to track the index is problematic.
This makes it almost impossible for an ETF manager to closely replicate the Vietnam Index by buying shares of the companies that comprise it. So the issuers of the ETFs decided to create their own, separate indices – rather than attempt to replicate the Vietnam Index.
But by creating their own benchmarks that comprise more liquid Vietnamese stocks, and even adding in some non-Vietnamese stocks, the indices tracked by the ETFs have lagged behind the actual Vietnam Index by a huge margin.
For example, in the last few months of 2016, two Vietnamese companies – Faros Construction and Saigon Beer – were the big drivers of the Vietnam Index. But the VanEck Vietnam ETF and the db X-trackers FTSE Vietnam held no shares in either one of these high-fliers.
Vinamilk is a large-cap stock that accounts for 11 percent of the Vietnam Index. Yet, it only carries an average 6 percent weight in the VanEck Vectors Vietnam ETF. The reason for this underweighting is the stock’s low daily traded volume. Big funds can’t buy enough shares without drowning out other investors and pushing the share price to the roof.
Airliner Vietjet, which is up 143 percent since 2016, is also absent from the VanEck ETF. That’s because it hasn’t been on the market long enough to meet the criteria of VanEck’s MVIS Vietnam Index.
These missing stocks have contributed to around 55 percent of the difference between the performance of the VanEck ETF and the Vietnam Index.
Do this instead
My message to the disingenuous marketers of these ETFs: just don’t. If you can’t make a good ETF, don’t make one at all. That would mean foregoing millions of dollars in fees, of course. And it would also mean not ripping off tens of thousands of investors – by serving up a terrible ETF that doesn’t do what an ETF should.
Investors should always research an ETF before they buy it. Review the performance of the ETF… and how that compares to the market itself. And if you decide to buy, keep track of the performance of your ETF. If it’s not doing what it’s supposed to be doing, sell it.
Publisher, Stansberry Pacific Research