Are you looking for the best ETF to buy? There are scores to choose from, but let me tell you which ones you need to steer clear of.
Caveat emptor is Latin for “Let the buyer beware”. The term has been used since the 16th century to warn of the risk that a product may have defects, or not meet expectations.
It’s good advice if you’re buying a used car or purchasing consumer electronics online. And buyer beware is also an important warning if you’re searching for the best ETF to invest in.
A glaring example is the performance of the Vietnam ETFs that claim to track the Vietnam Stock Market, but in fact do not.
Vietnam ETFs: A history of underperformance
Vietnam stocks have been on a roll – at least as measured by the VN Index, which tracks the 304 largest stocks listed on the Vietnam’s two stock exchanges, in Ho Chi Minh City and Hanoi. Since the beginning of 2016, the VN Index is up nearly 30 percent.
So you might think that investors in the two big ETFs that track Vietnam stocks are feeling good.
But no. The two “Vietnam ETFs” have done a terrible job of tracking the Vietnam market. Since 2009, as the graph shows below, the VanEck Vectors Vietnam ETF (New York Stock Exchange; ticker: VNM) has dropped 37 percent and the db X-trackers FTSE Vietnam UCITS ETF (London Stock Exchange; ticker: XFVT) has dropped 54 percent.
The abysmal performance of these ETFs – compared to the market they claim to track – is just one instance of an increasingly common occurrence: ETFs failing to meet their stated objectives.
Despite shortcomings, ETFs remain popular worldwide
Globally, the number of exchange-traded products (ETPs) has surged from 500 in 2005 to nearly 6,700 today. ETPs include ETFs and a similar product, exchange-traded notes (ETNs). The total value of assets managed by ETPs has grown from US$400 million in 2005 to US$3.8 trillion today.
ETPs have boomed because it’s easy and convenient 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.
There are two main kinds of ETFs – active and passive. Active fund managers rely on their own research and judgments to make investment decisions. Passive ETPs attempt to track specific indices of securities. For example, SPY is the largest ETF in existence, with US$234 billion under management, and it passively tracks the S&P 500 index, mimicking that index’s returns very closely.
However – as the Vietnam ETFs show – just because an ETF claims to track a given market, doesn’t mean it accomplishes what it promises.
ETFs are one of the best investment vehicles to buy. But something called tracking error is a big risk
As I’ve written about previously, there are many risks to ETF investing.
Tracking error is just one of these ETF risks. Some funds mimic their benchmark index better than others. The shortfall between an index’s performance and the ETF that tracks that index is called the tracking error.
One problem is: Sometimes an ETF does not own all the securities in the index it’s supposed to replicate.
You might assume that to replicate an underlying index, ETFs buy each index component in a proportion equal to its weighting in the benchmark. Some ETFs use this “full replication” strategy. Others employ “sampling” techniques, which means constructing a portfolio that is similar to the index but actually holds a different mix of securities.
Differences between the composition of the underlying index and the ETF portfolio can result in tracking error.
This is where the Vietnam ETFs get into trouble.
Vietnam’s unique tracking error
Vietnam is a communist country where the government, via State Operated Enterprises (SOEs), owns most of the shares of many publicly traded companies. As a result, the number of shares actually available for trading – which is called the float – can be tiny for many stocks. For many of the top companies on the Ho Chi Minh Exchange, less than 5 percent of outstanding shares freely trade.
This makes shares of a company 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 VN 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 virtually impossible for an ETF manager to closely replicate the VN Index by buying shares of the companies that comprise it. But there’s strong demand for Vietnam ETF products. So the issuers of the ETFs decided to create their own, separate indices rather than attempt to replicate the VN Index.
However, 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 VN Index (which, after all, is the most widely-used measure of the market) by a huge margin.
For instance, in the last few months of 2016, two Vietnamese companies – Faros Construction and Saigon Beer – were the big drivers of the VN Index. But the Vietnam ETFs VNW and XFVT held no shares in either one of these high-fliers.
Invest in funds – not ETFs – to gain exposure to Vietnam
For those who didn’t do their homework before investing in “Vietnam ETFs”, the awful performance of these funds compared to the Vietnam stock market no doubt came as a shock.
Unfortunately, Vietnam’s markets are mired in a bureaucratic swamp, which makes it difficult for an individual investor, let alone a foreign investor, to gain exposure to this emerging market directly.
If you’re set on exposing your portfolio to Vietnam, I recommend that anyone investing in Vietnam avoid the ETFs and consider actively managed mutual funds, which have had superior performance.
One of my favorite ways to invest in Vietnam equities is via the AFC Vietnam Fund, an open-ended fund that focuses on small to medium companies in the country. The AFC Fund’s performance has been stellar: It’s up 45 percent over the last three years through March. Over the same period, the VN Index is up 28.5 percent and the VanEck and db x-trackers ETFs are down 29 percent and 17 percent respectively.
With the open-ended AFC Fund, you’ll have higher fees, and you won’t be able to sell as quickly as you do with an ETF. Personally, I would rather pay higher fees to make money, than lower fees to lose money.
However, the AFC Vietnam Fund could be hit with liquidity issues during economic downturn, since the fund contains a number of small companies. And investing in country-specific funds is a concentrated bet on one market – and it’s not for everyone.
ETFs offer a way for investors to easily take advantage of specialized investment themes or strategies. But don’t take ETFs at face value – these funds don’t always do what they claim. Before investing, take time to read the fine print and carefully consider all the risks. Let the buyer beware.