A Big Blow For ETFs

Published in Investing on 19 September 2011

The UBS rogue-trader scandal may dent enthusiasm for ETFs.

Last Thursday, news broke of another rogue-trader meltdown, this time at Swiss banking giant UBS.

$2.3 billion and counting

A UBS trader, 31-year-old Kweku Adoboli, was alleged to have carried out a string of false trades dating back to 2008, in an attempt to cover up growing losses.

According to the latest press release from UBS, Adoboli's unauthorised losses now total $2.3 billion (£1.5 billion), $300 million more than the initial estimate of $2 billion. On Friday, Adoboli was charged with 'fraud by abuse of position' and remanded in custody by City of London magistrates.

Adoboli worked in the UBS Global Synthetic Equity business in London, hedging and balancing the trading flows arising from the group's exchange-traded funds (ETFs) business. Although the bank's equities business is 'again operating normally within its previously defined risk limits', it seems extraordinary that a single trader could run up huge losses from hedging at an ETF desk.

Other huge rogue trades have originated in equity index futures (Nick Leeson at British bank Barings), commodity derivatives (Yasuo Hamanaka at Japanese giant Sumitomo) and currency derivatives (John Rusnak at Allfirst, a US bank owned by Allied Irish Banks). Hence, I'm rather surprised that a 'boring' market such as ETFs has been hit by such a scandal.

ETFs under scrutiny

Even though no UBS client positions were affected by this massive, unauthorised trading loss, it shows the problems that can arise when back-office workers move onto trading desks.

Armed with inside knowledge of an investment bank's settlement procedures, traders such as Jérôme Kerviel at French bank Société Générale were able to outwit compliance procedures and exceed their trading limits to disastrous effect.

What's more, this latest scandal will undoubtedly shine a light on the somewhat opaque world of ETFs. To me, this is no bad thing, because the growing lack of transparency in the ETF world makes me nervous.

Although I'm broadly a fan of ETFs, I much prefer the plain-vanilla ETFs which track established market indices at very low cost. What make me nervous are leveraged ETFs, short ETFs and synthetic ETFs that use derivatives to reproduce returns, rather than directly holding the underlying assets.

Nevertheless, the market for ETFs has exploded in recent years. Since the launch of the first ETF in 2000, trading volumes for ETFs have risen by 40% a year. Also, there has been strong growth in esoteric, higher-charging ETFs, which go against the low-cost culture behind such traded funds.

Beware of TLAs

Once again, this scandal involves TLAs -- the three-letter acronyms much favoured by banking wizards and army soldiers alike. Personally, I'm very wary of TLAs and never use them without first explaining what they mean, because insiders often use such jargon to disguise information from the unwary.

For example, writing in last Friday's Financial Times, Gillian Tett pointed out the 'uncanny echoes' between this ETF scandal and the spectacular blow-up of CDOs (collateralised debt obligations made by slicing up mortgage bonds into various tranches). Ironically, it was UBS's heavy investment in AAA-rated subprime CDOs that cost the bank $50 billion in 'authorised' trades in 2007.

In short, investors buying specialist, complex and innovative ETFs may be taking on more risk than they realise. This is particularly the case when ETF promoters also act as counterparties to the derivatives underpinning a fund's returns.

Hence, this news from UBS could deal a blow to Mr Market's enthusiasm for ETFs, especially the synthetic ETFs that account for nearly half of ETF sales nowadays.

In reality, it seems that ETFs are not nearly as 'safe' and 'transparent' as their designers and promoters claim!

More from Cliff D'Arcy:

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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.

johnnygibber 19 Sep 2011 , 12:16pm

Hi Cliff

Excellent article - many thanks !

Not sure how Db x trackers are affected here - are they Physical/synthetic/cyborg etc ?
(Makes up currently 50% of portfolio in plain vanilla types.)

Could next article be on ETF providers and who has what type of ETF ?

Cheers
JG

johnnnytemplar 19 Sep 2011 , 12:35pm

I think in all this what has been missed is whilst a desk that traded etf's has caused the loss no actual etfs have been effected by it.
In relation to the above DB ETFs are synthetic and collateralised @ 110% of nav , details of collateral is posted on their website, I think credit suise do the same although personally I use the DB ones as they are the most most tax efficient.
For all the arguments over ETFs they do provide a service, decrease costs for the average investor and are quite safe.

CunningCliff 19 Sep 2011 , 2:40pm

Nice feedback -- thanks, johnnygibber and johnnnytemplar.

johnnnytemplar said, "For all the arguments over ETFs they do provide a service, decrease costs for the average investor and are quite safe."

I'll rewrite that bit to help you see the light, JT!

"For all the arguments over CDOs, they do provide a service, improve returns for the average investor and are AAA-rated safe."

Summary: never assume anything is safe in the financial world! ;0)

Cliff

actiondan 19 Sep 2011 , 2:53pm

So if only we could make the ratings agencies liable for the ratings that they issue, perhaps we'd have a far safer financial environment - and many fewer AAAs.

ANuvver 19 Sep 2011 , 3:39pm

Most of the iShares ETFs I've researched hold the underlying assets.
I mainly use them for one-shot access to bond markets - linkers, UK corporates, emerging markets, etc.

I think "boring" market sectors are especially vulnerable to this kind of scandal and indeed bubbles - less scrutiny.

johnnnytemplar 19 Sep 2011 , 3:50pm

I take your point about CDO's but ultimately the issue was that so little research was put in to find what the products were written on and you had no real recourse to the ultimate debt you were buying at least with an ETF you have an entitlement to a known basket of shares.
Ultimately ETF or funds in general expose you to sort of risk but then so does all investing since there is always a chance to lose your money, it is a case of minimising the chances of those risks.
All funds as we have been finding out contain a degree if counter party risk be that an ETF backed by a basket of shares that do not represent that index it tracks or a mutual fund loaning out it's stock to increase. If we are to mention all counter party risk then even having a nominee could be seen as a risk since if your holding went bust i doubt you would have access to your holding for quite some time.
Everyone is entitled to their views on whether ETFs are a good thing, I personally am ambivalent , I can see the uses for them as I say I use them to boost tax efficiency, I can also see why some people might be uneasy with their structure however the risks are really no different for those involved in any fund.
What I don't think anyone would argue with is that the vast ETF issuance has increased correlation across the stock Market which whilst not a good thing in my opinion for the moment does mean good stocks are getting dragged down with the not so good and gives us all a chance to pick them up a good levels.
As a slightly more out there thought I can envisage a point down the line where this correlation increase could undermine the ETF industry as it should throw up opportunities to be exploited by canny investors and people will conclude tracking the index has become inefficient.

CunningCliff 19 Sep 2011 , 5:49pm

Tullett Prebon CEO Terry Smith lays into ETFs in his latest Straight Talking blog:
http://www.terrysmithblog.com/straight-talking/2011/09/etfs-you-were-warned.html

Cliff

jackdaww 20 Sep 2011 , 9:27am

i stopped using etfs some time ago.

while simple basic real etfs may be ok its not hard to construct your own ftse100 tracker for example with 15 or less stocks and no etf risk.

a much bigger worry is nominee accounts and i am planning to go over to certificates completely.

why cant isa's be held under certificates ?

WillXster 21 Sep 2011 , 1:14pm

UBS Global 'Synthetic Equity' business...

Does this sound wrong to anyone else? I'll stick to boring investments like stocks and bonds thanks.

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