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.
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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