ETF risks lie in the balance

The exchange traded fund sector has been having a rough time lately. In June the Bank of England said ETFs were complex and opaque, but are they as risky as they sound?

The exchange traded fund sector has been having a rough time lately.

In June the Bank of England said in its Financial Stability Report that ETFs were complex and opaque, and it badged synthetic ETFs as particularly risky. More recently, the Serious Fraud Office warned that ETFs could be used for money laundering due to their lack of transparency.

But are ETFs as risky as they sound?

Some of the fuss around the products has resulted from their fast-growing popularity, which has caused regulators to suddenly sit up and take notice of them. Specifically, the Bank of England says ETFs may carry risks that investors are unaware of or do not understand.

The report said: "Although both types of ETF [physical or synthetic replication] effectively offer the same service to investors, synthetic ETFs appear to do so at a generally lower cost. It is possible that the additional risks associated with synthetic replication might not be fully understood by investors who are attracted by the lower costs."

These "additional risks" include the possibility of investors losing money if a counterparty or provider defaults.

There are various safeguards in place though. ETFs are regulated by Ucits, which stipulates that an ETF is not allowed to invest more than 10% of its prevailing net asset value in swaps issued by a single counterparty.

Most ETFs are also more than 100% collateralised. The collateral is held separately from the provider's assets and often reflects the index that the ETF is tracking. A FTSE 100 ETF might have a basket of UK equities as collateral, for example. So only a large movement in that particular market would affect the collateral. The market is normally checked daily by the provider, so the collateral can be topped up if it has fallen.

Seen in this light, synthetic ETFs are not as risky as some commentators believe, but they are complicated. The industry is split over whether private investors should steer clear of them.

Ben Gutteridge, a fund analyst at Brewin Dolphin, says headlines such as "ETFs pose a genuine systemic threat" tarnish a very useful and cost-effective area of the market, which is generally managed to a very high standard.

He is indifferent about whether an ETF uses physical or synthetic replication, provided the synthetic replication method adheres to "acceptable practices" - by providing collateralisation of more than 100%, for example.

Martin Bamford, managing director of Informed Choice, says he prefers physically replicated ETFs. "The risks associated with synthetic replication techniques are probably not as severe as the Bank of England suggests, although in the event of another major global crisis, it makes sense for the ETF to hold the underlying assets rather than rely on a counterparty and collateral to make up the difference," he says.

Bamford adds: "We would steer clear of synthetic ETFs, ETFs tracking obscure or illiquid markets and inverse ETFs. The mechanics and risks associated with these are too complex for the majority of investors to understand."

Gina Miller, a partner at SCM Private, a boutique that holds ETFs in its portfolios, says she is "astonished" by all the negative press. "The average synthetic ETF we hold has over 110% collateral backing. For our clients to actually lose money the bank has to go bust and the collateral fall by over 10%," she says.

However, while SCM Private says it will not switch out of synthetic ETFs, Evercore Pan-Asset, which also uses ETFs in its model portfolios, has announced that it will exclude synthetic ETFs due to "concern among [its] IFA partners and their clients".