Smith vs ETFs: The feud continues

Terry Smith, Founder of Fundsmith

One of the key problems with ETFs is many investors believe they are being sold index trackers when clearly many of them are not.

I have already provided evidence of how you can lose money on a leveraged long ETF when the relevant index goes up over a period when it is volatile and its rise is punctuated by sharp falls.

Similarly, you can lose money in a short ETF over a period when the relevant index goes down over a volatile period punctuated by sharp rallies. Hardly what one would expect from an index fund.

Shorting ETFs

To start with Miller dismisses my concern that, as ETFs are tradable, they are often used by hedge funds and investment banks who short them to hedge or speculate on certain risks and that the short interest can become a multiple of the size of the ETF with dangerous consequences.

He draws an analogy with shorting an individual company share, pointing out  “for someone to short a share requires someone on the other side to buy it”. This reveals an apparent lack of understanding of the difference between an ordinary company share and an ETF.

As a short seller in an ETF can rely upon the ability to create units in the ETF, the short interest can become multiples of the size of the ETF, a situation which should not be possible in an ordinary company with a fixed share capital, only part of which will be available to borrow so that short sellers can deliver stock to fulfil their short sale. 

I wonder if Miller could enlighten us as to how this is the same as shorting shares in Collins Stewart plc or any other public company, and why this does not represent a risk?

ETF transparency

Miller makes great play of the apparent transparency of ETFs: “ETFs publish the underlying holdings of the indices they follow daily and nowadays most [note not all] ETFs also publish daily a full list of their collateral where applicable.”

He contrasts this with mutual funds, such as my own, which do not publish a list of all their holdings.

As well as the top 10 holdings Miller acknowledges we have disclosed, Fundsmith has also disclosed the top five contributors and detractors to our year-end performance. In total this has provided disclosure of 16 of our total of 23 holdings, representing some 80% of the portfolio.

Given the low turnover on our portfolio, this does not change much. All of our holdings are in ordinary shares, we have no derivatives, hedges or short sales. Our definition of our ideal investor is one who understands what we are trying to achieve and our methodology so that they can have the emotional discipline to stay with us through the inevitable ups and downs of market and economic cycles and reap the benefits of the long-term compounding of the wonderful returns these companies can provide.

The issues presented by synthetic ETFs, short ETFs and leveraged ETFs with daily rebalancing and shorting ETFs make the headline in SCM’s brochure Exchange-Traded Funds (ETF) Simplicity, Transparency and Diversification risible.

Fees

Miller tries to make the case investment in ETFs is much lower cost than my own mutual fund.

He compares the charges on the Deutsche Bank MSCI ETF with my own fund’s total expense ratio, which he estimates at a range of 1.15% to 1.75% – I would agree with an estimate of 1.25% for the T-class shares.

However, as I am sure he well knows, this is a deliberate attempt to compare apples and pears to suit his own case.

If you own ETFs through his SCM Private Absolute Return fund, you will also pay his charges which are 0.75% pa plus 5% of any annual gain.

Alan Miller, Founding partner and CIO of SCM Private

I have to say it is always entertaining being lectured on how inherently unstable ETFs are from Terry Smith, given he was the CEO at Collins Stewart for many years, including the period in which the firm launched 28 split capital trusts, raising £2bn in funds from institutional investors.

Split capital investment trusts subsequently proved to be one of the most unstable investment structures of recent times, with investors in the split capital zero shares estimated to have lost £677m of the £785m they invested.

Unlike Smith, when I analysed his various fee classes I showed them all in order to be fair. Many retail investors access our portfolios via modern platforms whereby the annual management fee of our portfolios is between 0.5% and 0.75% per annum with no performance fees whatsoever. Mr Smith must have forgotten to mention this.

Smith compares our fees with his, but of course we are completely different – we are investing actively in various asset classes. Compared to the equivalent IMA Balanced Managed fund or IMA Absolute Return fund, we often save up to 50% of the real total costs as most other people have much higher dealing costs, fund expenses and underlying fund expenses.

However if you compare Smith’s retail class shares with the equivalent IMA fund bought through IFAs, you will find the charges are nearly identical. So much for the low cost.

Smith talks about short and leveraged ETFs and the dangers, but we have never used these either as we do not like the extra risks and costs attached. But if investors want such products, is it not for them to choose? 

As for disclosure, Smith says you can work out 16 of his 23 holdings by looking at his ‘detractors’ as well as his top 10 – can’t he simply publish all his holdings online – what has he got to hide?

There seems to be silence from Smith on my comparison with his own fund’s performance against the equivalent ETFs where he had already underperformed them.

The performance of his fund since inception in November 2010 was -7.4% compared to the 9.6% average return of the iShares and db X-trackers MSCI World ETFs over the same period.

As for our own performance our net returns – after even performance fees – for our Absolute Return portfolio from inception 8 June, 2009 to 30 April, 2011 was 29.8% versus just 12% for the average IMA Absolute Return fund.