ETFs no worse than other funds

Business school EDHEC challenges many of the issues raised with regards to ETFs in Europe. Many concerns expressed about ETFs relate to their structure, in particular synthetic ETFs which do not buy the assets they track, but rather get exposure via a derivative swap with a counterparty. The risk is that the swap counterparty, often an investment bank or insurance company, will be unable to meet its obligation, for example if it becomes insolvent.

However, if the ETF is compliant with fund legislation known as Ucits (Undertakings for Collective Investment in Transferable Securities) then it is obliged to hold collateral worth at least 90 per cent of the value of its assets to mitigate losses. In recent years, many providers of synthetic ETFs have taken a number of additional safeguards, for example, holding collateral worth 100 per cent or more than the value of the assets. Some providers have more than one swap counterparty, so if one fails there are others to fall back on. Others have both of these features as a safeguard.

EDHEC argues that ETFs should be classified by the risks of the investment they offer exposure to and the payoffs they generate rather than the structure.

But Stacey Ash, who runs funds of ETFs at Marlborough Fund Managers, argues that you need to look at the structure as well. "It is important to look at the counterparties and how many there are, what the collateral is and who holds it. With a physical ETF you will consider a number of things, including whether the ETF buys all the holdings in an index or is optimised," he explains.

It is also important to consider the investment risk and payoff, because it would not be fair to say that a physical ETF which invests in emerging markets shares is less risky and volatile than a synthetic ETF which tracks the FTSE 100. As with all funds, you should understand both the investments it makes and the structure of the fund and how it works. If you don't understand the fund structure, how it works and what the risks involved are, you shouldn't be investing in it.

Lending practices

Another concern raised last year was securities lending by physical ETFs. Many physical ETFs lend the assets they own to third parties for a fee as a way of raising revenue, which can help their returns and reduce costs for investors. The main risk with this is that the borrower becomes insolvent and the value of the collateral falls below the cost of replacing the securities that have been lost.

There are safeguards in place, for example, the ETF typically holds assets worth the value of the securities it has lent out. However, this practice means that while physical ETFs start off with a portfolio that includes the same or a nearly similar set of securities as the index they track, they can end up holding a basket of securities different from the index that is being replicated, exposing the investor to comparable levels of counterparty risk - not unlike a synthetic ETF.

"Provided the counterparty risk arising from securities lending is properly mitigated, which appears to be the case, portraying synthetic replication vehicles as presenting counterparty risk not present in physical replication vehicles is misleading since, unlike the former, the latter commonly engage in securities lending activities through which they can legally take on more unmitigated counterparty risk," says EDHEC. "As a group, managers of physically replicated ETFs provide investors with significantly less transparency than managers of synthetically replicated ETFs."

No synthetic ETF providers in Europe with the exception of ComStage lend the securities in their collateral. However, all physical ETF providers in Europe lend their securities with the exception of Think Capital, in some cases up to 100 per cent of the fund's assets. With the exception of iShares, physical ETF providers in the UK do not provide details of their collateral lending.

Double standards

Funds of all kinds engage in securities lending and this has been common practice for years. If you hold pension funds, investment trusts or unit trusts/open-ended investment companies, they may too be lending securities.

Wealth manager SCM Private conducted a study which found that the practice of stock lending is rife among active fund managers.

"Many investors will not be aware that certain retail funds are legally permitted to potentially risk 100 per cent of their savings through stock-lending," says Gina Miller, co-founder of SCM Private. "Current UK legislation does not require retail fund managers to disclose the risks of stock-lending in their investor marketing materials or to lend less than 100 per cent of their assets. They are not required to publish daily individual fund stock-lending exposures, the names of the largest borrowers or the precise make-up of the collateral backing these loans." Ms Miller estimates that, based on FSA comments that if investors are unable to understand the risks, products are not appropriate for retail investors, up to half the UK mutual fund industry would be deemed inappropriate for private investors.

"There is a large and widening transparency gap between ETFs and the rest of the funds industry," says Ben Johnson, director of European ETF Research at Morningstar. "Ucits-compliant ETFs have the same standards as any other Ucits product. But ETFs are allowing us to view for the first time some of these practices such as stock-lending that have gone on for decades."

One positive that has come out of the concerns raised, and the increased scrutiny by the regulators, is that it has prompted many ETF providers to improve their disclosure. But EDHEC argues that it is surprising that so much regulatory interest is being concentrated on a segment of the European investment management industry (ETFs) that only accounts for a small part of it, but is also already the most highly regulated.

Are the regulators being too heavy handed? "I don't think regulators have overstepped the mark, but they have failed to put the concerns in a broad context," says Mr Johnson. "ETFs are relatively new instruments, but adhere to all the regulations traditional funds do and face some of the same inherent structural risks."

Others suggest that the constant debate around ETFs and their risks is driven by parts of the fund management industry with interests at stake, for example physical ETF providers pushing the agenda on synthetic ETFs.

The active fund management industry, meanwhile, is losing sales to passives and looking to claw back territory.

"Active managers have been some of the most vocal opponents arguing against ETFs along a number of lines such as client vulnerability, counterparty risk and giving up outperformance," says Mr Johnson. "The arguments have been levied because ETFs have increasingly been taking share from active managers."

Examples of physical ETF stock lending

Source: Morningstar

Notes: Average on loan is calculated as average value of securities on loan over the past 12 months divided by the average net asset value (NAV) of the fund over the same time period. Maximum on loan is calculated as maximum percentage of the total NAV lent in a single day over the past 12 months. Net return to the fund is calculated as net 12 months' securities lending revenue to the fund divided by the average fund NAV over the same time periods.

HSBC figures were calculated from January to August 2011. HSBC does not disclose its collateral coverage.

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