Providers respond to Fundsmith’s criticisms of synthetic ETF’s

12th January 2011

The more successful you get, the more likely you are to come in for criticism. That is certainly proving to the case with Exchange Traded Funds, one of the fastest growing investment vehicles in the UK.

This year's leading ETF sceptic is City financier Terry Smith, a man not known mincing his words. He warns of misselling particularly of synthetic ETFs. However, perhaps demonstrating its new found maturity, the ETF market has hit back.

Mr Smith, who recently founded a new fund management business called Fundsmith, used his first annual letter to shareholders to warn that many investors see ETFs as simple trackers when, he argues, many synthetic ETFs are nothing of the sort.

The concerns are outlined on his Straight Talking blog site 

He warns that following the credit crisis, and given the collapse of Lehmans and the AIG rescue, counterparty risk on swap agreements could be hugely significant particularly if world markets experience another bout of the sort of vicious contagion seen during the credit crunch. He is also concerned that it may not be possible to replicate markets where the underlying liquidity is poor, such as with some emerging market equities, despite many investors and their advisers using them for this purpose.

However ETF providers have hit back saying they have the collateral to withstand a contagion shock quoted here in IFAonline.co.uk. Etfs. Evercore Pan-Asset chief executive Christopher Aldous says: "We look at this very carefully. Most synthetic ETFs are now very, very well collateralised, rebalanced on a regular if not daily basis and topped up to at least 100% of the fund's NAV."

On Money Marketing, TCFDan believes that ETFs do require more due diligence from investors and their advisers.

He says: "There is no doubt that there is a level of due diligence required for synthetic ETFs. And there are sound structures that will mitigate the counter party risks – many already do. But it is also true about almost any retail fund – what about the stock lending risks in many apparently simple mutual funds?"

However Schroders is also questioning whether ETFs are the best strategy for accessing commodities.

David Mooney, co-head of investments at Schroders NewFinance Capital believes that actively managed returns will be better, that active managers are better at managing risk and that ETFs tracking total return indices do not always reflect spot prices in commodities markets.

HSBC, which offers ETFs acknowledges there is a sales and marketing challenge, particularly with the products, because the ease with which anyone can buy the listed product.

It is calling on the ETF industry to remember that its success to date has been built on transparency. Farley Thomas, Head of ETFs at HSBC, said: "As ETFs are listed retail products and can be bought by anyone it is harder to control the message and communication, hence there is a sales and marketing challenge for product providers, especially when a product is more complex as is the case with derivative-based ETFs, notably the more exotic leverages/inverse ones.

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