So How Safe Are ETFs?

Published in Investing on 6 June 2011

ETFs are getting a bad press. Should investors be worried?

A lot of people have a lot of time for maverick City veteran Terry Smith, the chief executive of Tullett Prebon (LSE: TLPR), and the head of fledgling fund management business Fundsmith.

Among other claims to fame, his 1992 book Accounting for Growth is still required reading for finance directors wanting to put the best possible gloss on financial results that leave something to be desired.

So when Mr Smith starts questioning whether ordinary investors should invest in ETFs, and worries that many ETFs leave investors exposed to risks that they neither see nor understand, it's only natural to be concerned.  Especially when some of his thoughts are published verbatim in the Daily Telegraph.

I'm not going to reprise Mr Smith's worries in detail.  That's what the links in the paragraph above are for.  But in essence, his argument is this:

"I suspect a lot of retail investors think that ETFs are the same as index funds. Some of them are, but many aren't. In particular, the performance of short ETFs and leveraged ETFs may diverge markedly from what an investor who believes they are simply index funds would expect.

Plus, many ETFs do not contain a basket of the underlying securities or assets which they are attempting to track. Instead they hold asset swap agreements with a counterparty (often the bank which is the ETF sponsor) which aim to replicate the performance of the index or asset concerned.

There are obvious dangers in such an arrangement in the areas of counterparty risk and collateralisation of the sort which caused so many problems during the Credit Crisis."

So should we be worried?

The simple answer is yes. While I'm no expert on the intricacies of exotic ETFs, I've spoken to people who are, and Mr Smith's concerns appear to be well-founded.

Nor is Mr Smith alone in expressing reservations about ETFs.  The Financial Stability Board has also recently published a paper on the subject.  Again, it's well worth a read if ETFs form a decent-sized chunk of your portfolio.

And ETF provider iShares, no less, is in full agreement that a number of recent developments within the ETF industry require closer scrutiny.

Joe Linhares, iShares' European head, for instance, says this:

"ETFs are one of the most innovative financial products of the last two decades but we believe a number of recent developments within the ETF industry require closer scrutiny. It is encouraging that The Financial Stability Board calls not just for transparency but also for providers to evidence to investors a demonstrable infrastructure to support transparency."

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Don't panic, Mr Mainwaring

That said, expressing concerns over some ETFs isn't the same as expressing concerns over all ETFs.  Not every ETF is leveraged, or aims to short a commodity or index, or involves complex derivatives.

Farley Thomas, head of ETFs at HSBC (LSE: HSBA), which over the last couple of years has launched a wide range of low-cost ETFs, provides some pointers as to what to watch out for:

"In the case of swap-based or synthetic ETFs, you really do need to look closely at the ETF provider, the counterparties and the custodians," he says.  "But you've got to have a sense of proportion: there's a lot of scaremongering around, and many ETFs don't warrant it."

And in Mr Thomas' eyes, four simple tests distinguish barge-pole ETFs from bargain ETFs. Ask yourself these questions, he urges, before taking the plunge with a given ETF:

  • Is it simple?

  • Is it transparent?

  • Is it good value?

  • Does it employ physical replication as opposed to swaps and derivatives?

"These are the four boxes to tick," he stresses.

Market leaders

Helpfully, too, he provides some reassurance in the case of the index-tracking ETFs that are most favoured by UK investors.  And that reassurance applies not just in the case of ETFs tracking the UK's FTSE, but indices such as the S&P 500 and other popular foreign markets.

Both HSBC and iShares employ physical replication, he explains. Which means that the underlying shares have been bought, and are held -- duly ring-fenced -- by a third-party custodian. And because of the dominance of HSBC and iShares in the UK retail marketplace, that means that many UK investors should have little to worry about.

Not so European investors, he warns. Among European providers, only around 55% of ETF products employ physical replication, with 45% using derivatives and swaps. 

Stick with the mainstream providers and products, in short, and you should be alright.  Venture further afield, and caution is advisable.  Don't say Terry Smith didn't warn you.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

Sidekicker101 06 Jun 2011 , 7:56am

As an ETF holder, even if the provider goes bust, you have a claim to the underlying assets don;t you?
Furthermore, if you have a massive amount of money in 1 ETF (say an index ETF), then split up the money into more than 1 index ETF so it is split across different providers.

jackdaww 06 Jun 2011 , 9:35am

i did have them but not now.

dont like the sound of derivatives and counter party risks.

best to have trackers which actually hold the shares - there are some low cost ones.

its not hard to do your own tracker using these posts as a guide.

BarrenFluffit 06 Jun 2011 , 11:24am

I think the industry is facing the same sort of dilemma as other more established fund types. If the universe is diverse enough then different etf's have to be grouped into different classes so investors can see what their getting.

piecan 06 Jun 2011 , 11:57am

I am sick & tired of the financial services industry constantly finding new ways to rip us off and getting away with it. Whenever anything goes wrong it is always the "small" people who lose money - the ones who provide the gravy train for the sharks. When are we going to have a system of licensing for any new product, when it is vetted before it can be sold. Similar to drugs, among other things. If approved, it would then be rated on a numerical scale to indicate its degree of risk. All that happens now is that retail investors are told to be wary after they have invested their hard-earned. When it is too late.

curedum 06 Jun 2011 , 4:52pm

I don't think you've got much to worry about provided you stick to "plain vanilla" ETFs, as Farley Thomas says. Straightforward index-tracking funds using physical replication should be almost as safe as tracker unit trusts - "almost" because they're based off-shore.

UrbanDreamer 07 Jun 2011 , 8:19am

Straightforward index-tracking funds using physical replication should be almost as safe as tracker unit trusts - "almost" because they're based off-shore.

As safe does not mean absolutely safe. FTSE100 index trackers use physical replication. Those that track wider or smaller indices don't. The same is of course true of ETF's

It's a case of read the documentation I fear. Personally I get a bit irritated by those who claim that nobody can or does.

ie All that happens now is that retail investors are told to be wary after they have invested their hard-earned. When it is too late.

I think that you will be able to get compensation and serious fines by the FSA from ANY company that didn't warn you that you should ensure that the product was suitable for you BEFORE you bought it.

I have owned ETF's that have no physical assets (BUL). Guess what, I knew the fact before hand as I had read the documentation.

piecan 07 Jun 2011 , 12:58pm

Obviously, UrbanDreamer is a sophisticated investor who can look after himself/herself. I'm sorry I irritated him/her but two things, also, irritated me. 1. Being misquoted - I didn't say "nobody can or does read the documentation." 2. People who believe they are superior to others. That's why I would rather listen to someone who knows what they are talking about, such as Terry Smith, who I quote, "accurately." "He worries that many ETFs leave investors exposed to risks that they neither see nor understand and it's only natural to be concerned." There is nobody in this country more against the nanny state than I am, but the point I was making is that the standard of regulation is pathetic, and we all suffer.

straightgoods 07 Jun 2011 , 9:58pm

What if investors have massive shorts and synthetic shorts and shorts on shorts in an ETF? These derivative shorts are not worth the paper they are not written on. An unregulated ETF can easily go bankrupt in a black swan situation. If that happens, who gets left holding the bag? The operator of the fund? The counterparty bank? The retail investor? One guess per customer.

steveunsworth 08 Jun 2011 , 3:45am

I'm afraid SanMiguel101 that you have shown the innocence that makes these products so potentially dangerous. It's not the ETF provider's credit-worthiness that is the main issue - it's the counterparty to a derivative your ETF provider might have made. Sure - the ETF provider would have a claim to the counterparty's underlying assets if the counterparty failed on a trasaction but there are rarely any significant assets left when a financial institution goes illiquid, then busts.

Products that are too clever by half normally end up too overvalued by more than half.

UrbanDreamer 08 Jun 2011 , 8:45am

Sure - the ETF provider would have a claim to the counterparty's underlying assets if the counterparty failed on a trasaction but ...

That bit is absolutely correct (though the rest may or may not not be for a given ETF). However to restate the post that I made, READ THE DOCUMENTATION.

Here is a quote from such documentation on a ETF that I owned. (when quoting I either use italics or the quote character, if those are absent it is not a quote)

"Each Commodity Contract Counterparty posts collateral on a daily basis into a separate pledge account in their name held with The Bank of New York Mellon (BNY). A separate account has been established for each commodity Contract Counterparty and each account is monitored and valued daily by BNYM."

So in this case it is the reliability of BNYM that is the risk.

My point is that it IS in the documentation which is provided. Personally I don't regard the decision to read it as especially sophisticated, but possibly some do.

piecan 08 Jun 2011 , 1:04pm

The dictionary gives several meanings to the word sophisticated. The one I like is - "pretentiously or superficially wise".

Dozey1 08 Jun 2011 , 4:09pm

Of course, if they are guaranteed by a bank nothing can go wrong, nogihi anc og worgn, othgin nac og norwg... etc.

I won't touch any of 'em.

westwinds3 09 Jun 2011 , 7:29am

What about the scary point Terry Smith makes on short selling? Are you safe with even a simple fully replicated ETF? He makes the point that because ETF shares are created on demand, a short seller does not have to borrow shares to create the short. This means that there is no limit to the potential size of the short position.
If I understand it, it means that when you buy shares in even a vanilla ETF, you may actually be a counterparty to a short seller of ETF shares that do not yet exist. He quotes an example of an ETF where there are are far more shorts than there are shares. Presumably you could reach a situation where the shorts are greater than the underlying index.
How can one find the short position on an ETF one holds?

teecee90 15 Jun 2011 , 9:57pm

Even plain "vanilla" ETFs have similar counterparty risks to synthetic ETFs if the provider (as most do) is renting out its securities to hedge funds et al for short selling.

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