ETFs: Weighing up the risks

11th November 2010

ETFs have undoubtedly been the subject of some controversy in recent months. A US-based advisory group called Bogan Associates has suggested that an ETF could collapse due to pressure from short-sellers.

That just added fuel to the fire for many investors who were already concerned that counterparty and collateral risks that accompany these investments, due to the derivatives used within ETFs, made them too risky for many investors.

Friend of foe?

Are ETFs truly the next bogeyman of the global economy? Or have the fears been over-blown?

Bogan Associates' original White Paper has been widely picked up. FT Alphaville, for example, has a feature on it, written by Andrew Bogan himself.

Bogan's arguments are complex, but centre on the fact that hedge fund managers are increasingly using ETFs to take short-term positions on markets.

This has, he says, led to some ETFs having shockingly large short interest compared to their number of shares outstanding, which in turn leads to the risk that the ETF could collapse.

Bodan's arguments have been widely refuted by independent experts in the area. Bradley Kay, an ETF analyst at Morningstar explains why an ETF cannot collapse in the way Bogan describes.  He goes a little further for the maths aficionados, but this piece is for the technically-minded only.

There have also been nerves about collateral and counterparty risk in ETFs. The arguments are outlined here in Fund Strategy. The main premise is that many ETFs use derivatives to replicate an index, rather than investing in underlying stocks. While derivatives-based ETFs tend to track indices more closely, they create additional risk.

Insuring against risk

The basic mechanism is that the ETF provider does a deal with a broker to replicate the performance of an index. There is a risk that the broker does not honour his part of the bargain or goes bankrupt, so the ETF providers take collateral from them as an insurance policy.

This could be government bonds, or whatever else is agreed by the provider. This has been controversial because pre-Crunch, ETF providers were reasonably flexible in their demands for collateral and accepted instruments such as the now-infamous asset-backed securities.

This raised the possibility that investors who had bought into a FTSE 100 ETF, would find they were instead invested in a load of illiquid fixed income assets in the event of default by a broker.

Tighter collateral requirements

The majority of ETF providers have substantially tightened up on their collateral requirements and most will list them on their website.

Equally, the majority of ETF providers are extremely clear about their replication strategy. For example, HSBC's FTSE 100 fund factsheet clearly outlines its approach –

Nevertheless, it has made some people sceptical, as this article on Fund Strategy reports.

It has even got some worried about ‘hidden costs' as this Motley Fool thread demonstrates. But as EdSwippet points out on the thread: "Any internal "churn" within either a fund or an ETF would certainly add to costs.

"That said, both index tracker funds and tracker ETFs will be much less susceptible to this than active funds, and there should be no real difference between funds and ETFs that track the same index."

And in this, he sums up an important point. A lot of the questions that have been raised about ETFs, such as counterparty or collateral risk, also apply to active funds. Active funds also use derivatives and also use brokers. It's simply that everyone spends their time fretting about what the manager is doing with an active fund rather than these more esoteric risks.

No evidence

Of course, a few may prove bad investments, but that will be because the underlying holdings have been a bad investment. Investors should watch out for fee differences and tracking errors (Morningstar has an excellent guide to selecting ETFs) but this is not the same as worrying about a collapse in the structure.

There seems little evidence that ETFs are likely to become the next bogeyman of the financial markets.

Leave a Reply

Your email address will not be published. Required fields are marked *