ETFs: ‘could pose a significant danger to investors at times of high market volatility’

6th February 2012

For many, the term ETF is rapidly becoming synonymous with future problems, with many suggesting that the higher ETFs fly, the bigger their eventual fall. They see consumer detriment as many instruments sold to individual investors such as absolute return funds may be wholly or partly dependent on ETFs which are difficult to understand or even impossible to disentangle from the underlying fund.

This week, watchdog European Securities and Markets Authority (ESMA) issued a consultation paper to respond to investor fears. But it is unlikely to assuage critics such as whistleblower Terry Smith, chief executive of interdealer broker Tullett Prebon.

He told Reuters that "ETFs are being widely mis-sold as a low cost form of index tracker when in fact they are highly complex vehicles best suited to hedge funds and proprietary trading desks." He warned the unwary investor buying into an ETF could be exposed to highly complex opaque products more suited to high frequency traders and hedge funds.

"If you read the description of the product they use the words synthetic, derivative, swap and counterparty. If you can't figure out what the problem might be here you need to study the history of the last four years more carefully," he said.

ETFs grew by an average 40% annually over the first decade of this century from virtually nothing to $1.2trillion. The increase has now slowed. 

ETF issuers promote their tradability – like shares on an exchange. Smith said: "This feature is irrelevant to non-professional retail investors that makes the vehicles attractive to short sellers. The only people who want ETFs to trade intraday are bank proprietary trading desks, hedge funds and algorithmic traders. The average investor is none of the above."

He warned: "Though ETFs are increasingly marketed as low cost, they are highly profitable for issuing banks. The (visible) charge to the investor is "a very small tip of the iceberg on what they (the banks) are making. There's basically a gravy train," he said.

He is not alone. Just before Christmas The Guardian highlighted a warning from brokers Williams de Broe who called for regulators to ban the sale of more complex ETFs to retail investors. The broker also stated that "the proliferation of such funds over the last decade could severely exacerbate a market downturn."

De Broë's head of research, Jim Wood-Smith, said: "ETFs could pose a significant danger to investors at times of high market volatility. We welcome the increased attention regulators are paying to these products, which remain relatively untested."

He focuses his firepower on "synthetic" ETFs, which instead of tracking an index such as the FTSE or a basket of commodities, use derivatives to gain exposure, with risks passed on to third parties. Wood-Smith says: "These contracts are not as transparent as we would wish, and there is a danger counterparties could go bust. I am not sure investors realise the risks involved."

In the US,  the Securities and Exchange Commission (SEC) is also concerned. Last October, it announced an agency-wide review to ensure ETFs are adequately transparent and not fuelling market volatility. It is looking at the adequacy of investor disclosure, liquidity levels and transparency of underlying instruments.

The new proposed ESMA regulatory environment will not stop these doubts. The Financial Times headed its account "Regulator goes easy on ETFs". ESMA has stopped short of classifying synthetic ETFs as complex instruments which would have prevented their sale to investors without prior advice.

It is basically a get out of jail free card for the ETF world. The worst that would happen is that disclosure requirements would increase. FTAdviser has a summary of the 77 page long interim report which talks of labelling and "identifiers" with the prospect of regulatory action to ban unsuitable products a very much long term threat.

The summary is long on information requirements – but these will not stop individual investors from buying or selling higher risk instruments. A long list of disclosures is no help when someone is trading – they simply do not have the time to read complex material and, even if they did, the ESMA proposals do not suggest the use of "comparators" so potential investors can see how each factor revealed lines up against other funds or their importance weighting.

ESMA will now find itself potentially at loggerheads with the SEC and with the UK's FSA which, in its new incarnation as the Financial Conduct Authority, will want to be seen reversing previous light touch regulation.


More from Mindful Money:

ETFs: All you ever needed to know

Are 'active' ETFs the answer?

Volitility ETFs – Profiting from a crisis

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