Concern over ETFs after problems with swaps and a warning on short trading

Part of the attraction of exchange traded funds (ETFs) is simplicity. Investors get the performance of an index or commodity, less fees, job done. However, the post-crunch environment has concentrated attention on the way ETFs are structured, particularly the underlying derivatives that back some of them.

Whole strategies have emerged to exploit these inefficiencies – for example, Armstrong Investment Managers invest in arbitrage strategies that aim to profit from the difference in price between spot and futures.

Another controversy over ETFs was generated by a white paper from Bogan Associates. This looked into the widespread practice of shorting ETFs. ETFs are used by hedge funds and other traders looking for a simple way to mitigate broad market risks, or neutralise beta, with a single trade. Some ETFs in the market are net short and therefore owners of ETF shares often far outnumber the ownership of the underlying index equities by the ETF operator.

Bogan Associates argued that this could create a run on ETFs and force a wind-up in which retail investors would be hardest hit. However, Kay argues that while naked short-selling does not exist, it is impossible for an ETF to ’fail’ in this way. He says that the standard safeguards in the institutional share lending market prevent this short-selling from creating “phantom shares” in the market that lack backing assets.

These issues are in addition to all the more everyday issues associated with ETFs such as TERs or currency, which can cause divergence from an index, but experts vary on the extent to which these things are a problem.

Kay says that it is only a problem because ETFs are the most simple and transparent product where these risks have come up. In fact, they are present in almost all mutual funds – most use derivatives and many do stock-lending – but the focus for active funds is always on how the manager is performing.

Mairs is more concerned, though not necessarily because ETFs will fail and investors will lose considerable sums, but because most investors do not understand the risks they are taking.

“It is not just stockpicking or tracking error risk. Our view is that most investors – even professional investors – are not on top of the risks. They have a view that passive investments are commodity items and that it just not the case,” he says.

“If a counterparty goes bust, investors will find that instead of being invested in a European equity tracker, they are invested in European government debt. It is a rare event, but it could be catastrophic.”

Mairs says that investors need to do their research, or find someone who will do it for them. He says that no one ETF provider stands out as being better than any other and both swap-based and physical ETFs have their place.

He is also worried it may become more of a problem as ETF providers launch ever more esoteric strategies. The ETF market has seen the emergence of products offering geared returns, short exposure and ’active’ strategies. Mairs says that the mechanics of these funds are often complex and require research. In America, approval of several funds has been suspended by the Securities and Exchange Commission pending an examination of the underlying derivative structures.

The risks of ETFs may also become a greater concern as the Retail Distribution Review looms and more advisers contemplate a passive strategy for client assets. Also, independent advisers will have to demonstrate they can advise on all assets including ETFs, which will include an understanding of the risks involved. There is a danger that some of the mistakes associated with structured products are repeated for ETFs.

There is a temptation after every crisis to look for the next upset. Despite the controversies, it seems unlikely to be ETFs. However, there are risks in ETFs that are not understood by the market and ETF providers have admitted that there is an education gap. The concerns highlighted do not make them a no-go investment, but they do suggest that greater care is needed in their selection.