Exchange Traded Funds (ETFs) are a sophisticated type of unit trust allowing traders to create small diversified portfolios without the huge transaction costs.
Unlike traditional unit trusts, traders can trade ETF’s on the stock exchange at any time rather than wait until the closing price is calculated at the end of the day. They are both flexible and liquid and suit day-traders though concerns exist about how they are regulated.
ETF brochures warn investors that cash and bonds offer poor returns and that they should therefore consider funds that can achieve stock market returns similar to indices like the FTSE 250.
Misleadingly, the brochures often claim that they can “mimic” the stock market with substantially reduced risks. If they could, fund managers would probably be too busy looking after their own funds rather than yours.
Some believe that ETFs are very risky and therefore a ticking time bomb.
There is, for instance, a bid difference – about which investors are often unaware – between synthetic ETFs and physical ETFs.
The former never buy the shares they cover but promise investors that they can simulate stock market returns by using derivatives.
Derivatives have an important advantage over buying physical shares. Transaction costs and stamp duty costs are lower and they are very flexible.
However, these ETFs are exposed to the counterparty who provides the derivatives, normally an investment bank.
What happens if the counterparty goes bust? A fund that owns the physical shares need not worry but an ETF over exposed to derivatives with the troubled counterparty should.
With financial institutions going through a rough patch at the moment, investors should feel concerned.
The EDHEC-Risk institute claims these fears are misguided.
Its paper* What are the Risks of European ETFs? says ETFs have the same risk profile as traditional investment funds. This is because traditional funds often lend securities to financial institutions and use derivatives.
As a result, they too are exposed to investment banks collapsing.
Ucits Directives
EDHEC also states: "Almost all European ETFs abide by the provisions of the Undertakings for Collective Investment in Transferable Securities (Ucits) Directives." These rules force ETF managers to act in the best interests of their clients.
They also reduce or eliminate conflicts of interest.
Assets are owned and managed by an independent depositary, which acts as an important safeguard for investors.
There are also rules on diversification, leverage and risk management.
Furthermore, the issue of counterparty risk is limited to instances where ETFs use complicated derivative transactions. In short, the difference in risk profiles between synthetic ETFs and more traditional funds is not as great as most people believe.
EDHEC nevertheless warns that there are concerns about the way that ETFs in general are regulated.
“We find that creating an artificial distinction between physical and synthetic replication ETFs would introduce confusion. When associated with a communication about the risks of derivatives, such distinctions could lead to mis-selling.”
In other words, a salesman could mislead you into believing that all physical ETFs are safe and all synthetic ETFs are dangerous.
In reality, an investor could end up with a highly leveraged physical portfolio which is a lot more dangerous than the synthetic counterpart.
There is also the danger that vested interests will exploit the “fear” of the word “synthetic” by encouraging regulators to pay more attention to synthetic ETFs and to leave physical ETFs to “light regulation”.
US regulators appear to understand this problem: European regulators may not.
For instance, one major provider of ETFs told US regulators that the name of the ETF was unimportant. What is more important is the risk profile or exposure of the ETF.
The same provider, according to EDHEC, told European regulators that “the distinction between physical and synthetic replication” is very important. EDHEC wryly remarks: “A foolish consistency is the hobgoblin of little minds.”
If a fund is simple, transparent and all fees are shown clearly, there is perhaps no need for regulation. The investor fully understands what he or she is getting and the risks.
Heavy hand
EDHEC argues that the heavy hand of the regulator should be confined to complicated ETFs that could mislead the investor.
Again be careful. When it comes to complexity, regulators often cannot cope and end up giving false reassurances. As JP Morgan has shown in its recent “whale trading” debacle, complexity can lead to high but concealed leverage, hidden losses and inappropriate fees and bonuses.
Fortunately, most ETFs are passive and their payoff profile is easy to understand, even if some are synthetic.
Given the choice, ETF distributors may try to sell you an ETF that is highly leveraged and complicated (and supposedly well regulated) – the commissions on complex transactions are easier to disguise and are a lot higher.
Experienced investors can create an ETF structure themselves using derivatives like the FTSE 250 Futures contract – saving on unnecessary fees.
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Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options
