Smart investing: Do this to avoid financial indigestion

There’s a small difference smart investing – and investing in a way that will lose you money. And there’s a very big difference in the results: A comfortable existence or scrimping to get by and dreading retirement.

What am I talking about?…

Imagine you’re at the supermarket buying some yoghurt. You’re health-conscious, watching your weight, just trying to eat right. You see some single-serving pots of “Yoplait Greek Fat-Free Blueberry Yoghurt”.

Perfect, you think. Fat-free means it’s more or less healthy. Right?

But… if you take the time to read the label you’ll see that two small pots of this stuff contain the same amount of sugar as a regular 12-ounce (355ml) can of Coke.

That’s nearly 10 teaspoons of sugar. You’re buying junk food without even realising it.

Read the label of your investments – that’s smart investing

Investors make the same kind of mistake all the time. They don’t pay enough attention to fees or financial advisor costs when it comes to brokers. They don’t pay enough attention to structured derivative product fees in particular. (Believe me, structured products are like sausages – you don’t want to see how they get made.)

When it comes to ETFs, what it says on the label and what it does in practice can be two completely different things. The only way you can adequately inform yourself is by understanding the contents. And to do that, you need to understand the underlying index.

Let me explain.

An ETF is just an exchange-traded fund that tracks a particular underlying index. The underlying index defines the rules which dictate the stocks or financial securities that are included in the ETF.

If the name of the ETF is what you see on the food label, then the underlying index is basically the list of ingredients and the recipe. The best ETF to buy is one that really contains what the label – that is, the name – suggests.

Let’s say you’re looking to diversify your fixed income portfolio. You think about adding in some China exposure. The growth story is attractive, and it’s not a bad idea to get some exposure to both the Chinese economy and currency, the renminbi (or yuan).

You google “China bond ETFs” and you come across the PowerShares Chinese Yuan Dim Sum Bond ETF (NYSE; ticker: DSUM).

You recognise the name PowerShares as one of the leading ETF providers. That’s a good start. But since we’re investing smart, let’s look at the ingredients.

If you’re not sure what “Dim Sum” means, a quick internet search tells you that it’s a popular Hong Kong cuisine consisting of small steamed or fried dumplings. (If you haven’t tried it, you should.)

A slightly more refined internet search tells you that “dim sum bonds” are renminbi-denominated bonds issued outside of China.

You note the expense ratio (that is, the annual fee ETF charge) of 0.45 percent is high. But this is a specialised foreign currency fixed-income ETF, so that’s understandable.

Finally, because this is a bond ETF after all, you check the yield. The Invesco website (PowerShares was acquired by Invesco in 2006) indicates the ETF yields around 4.3 percent before fees.

Everything looks good, so you put the order in with your broker. This “Chinese Yuan Dim Sum Bond ETF” appears to do everything its name suggests. You’ve diversified into China.

Is this a smart investment? Not really…

Let me ask you a question:

What do the British government, Korean financial institution Shinhan Bank, oil giant British Petroleum, Hong Kong financial services company Southwest Securities, New Zealand dairy cooperative Fonterra, German carmaker Volkswagen, and Malaysia’s national mortgage corporation Cagamas all have in common?

Absolutely nothing whatsoever, except that you now own some of their debt. These entities have all issued offshore renminbi bonds which are included in this ETF.

That’s the only thing they have in common.

If you dig into the prospectus you’ll see that the “recipe” outlined by the underlying index means you can throw any “ingredients” into this ETF.

The bonds just need to be issued and settled in renminbi outside of China, have a minimum maturity of one month, and an outstanding notional amount of at least one billion renminbi (US$145 million).

How about a minimum credit rating requirement?

No, none required. As a result, nearly two-thirds of the bonds in this ETF aren’t even rated at all. Bonds can be issued by governments, corporations, agencies or supranationals.

As an investment, this makes no sense to me. All this ETF does is provide you with a bunch of bonds whose sole commonality is being issued outside of China in renminbi!

You might as well buy shares in a “Stansberry Churchouse Financial Fruit ETF”, a fund giving you exposure to stocks that bear the name of a fruit. Holdings could include Apple Inc., Orange S.A., Grape King Bio Ltd., and Maui Land & Pineapple Company.

What’s more, in the Dim Sum ETF, the “recipe” says that nearly anything can be thrown into the fund over time. You see, as the bonds in the ETF mature, they will be replaced with others – but you have no idea what. It could be any company, anywhere in the world, with any credit rating, just so long as the bond is issued in renminbi outside of China.

To be clear, I’m not saying that PowerShares is misleading you any more than Yoplait is with its yoghurt. Their respective labels are both technically correct.

But just because an ETF provider is a big household name, it doesn’t mean what they’re selling makes sense. (That’s also true with Vietnam’s ETFs.)

Read also: Don’t be blindsided by these 2 ETF risks

Always spend a few more minutes and properly read the label.

Good investing,

Tama

P.S. At Stansberry Churchouse Research, we give you a step-by-step guide on how to invest money in stocks and ETFs that gives you good exposure to Asia. To download our beginner’s guide, click here.

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