High risk warning threat to growth of exchange traded funds

Their popularity continues to grow rapidly but that could now be checked after concerns were raised over the risks they may pose to investors.

ETFs are collective funds that are traded on the stock exchange and, like trackers, seek to replicate an index or a group, such as commodities, currencies or countries. At the most basic, for example, a FTSE 100 ETF would track the FTSE 100.

The market has boomed in recent years as investors have increasingly sought exposure to specific assets without incurring the costs or risks of active investment management. The chief appeal for most investors is that ETFs are, usually, considerably cheaper than actively managed funds, with charges typically around 0.5 per cent.

David Gow, a financial planner at Acumen Financial Planning in Edinburgh, said many investors and advisers switched to ETFs and other passive investments (such as trackers) in the wake of the bear market.

"The market plunge in 2008 was much harder to explain to investors in actively-managed funds," he said. "While active funds saw massive outflows during the recent bear market, passive investments still had inflows, both to stocks and bonds."

The soaring popularity of ETFs is due to their low charges, tax efficiency and easy diversification, said Gow. He believes the market will continue growing as more investors tap into their benefits.

"With over 1,600 ETFs listed on 43 stock exchanges worldwide, ETFs offer a huge amount of choice to investors looking to track everything from developed and emerging stock markets to themes, like infrastructure and water," he said.

But an alarm was sounded last week over the risks inherent in some ETFs. The Financial Stability Board (FSB), which represents the world's main regulators and central banks, raised concerns over "disquieting developments" in the ETFs market and called on providers to do more to help investors understand the risks. The liquidity of the funds was among the big issues, with the FSB pointing to potential problems for investors in the event of a mass sell-off.

There are also counterparty risks, relating to the potential for the organisation underwriting the shares to default. Many ETFs have underlying securities that are not linked to the index they track, meaning few investors would be aware of the counterparty risks to which they are exposed, echoing the subprime mortgage crisis. But Gow believes that risk is limited.

"Db x-trackers ETFs, for example, can be exposed to a maximum of 10 per cent net counterparty risk with a single counterparty. To further reduce or eliminate potential counterparty risk, most equity, commodity and currency ETFs are fully collateralised, meaning that counterparty risk is 'hedged out'."

One expert who is both appreciative of the benefits of ETFs and wary of the pitfalls is Charles Fotheringham, head of investment management at Gillespie Macandrew.

He noted that the popularity of ETFs has triggered a surge of increasingly esoteric products hitting the market. These, more than traditional ETFs, use options and futures or other derivatives as a way of replicating a particular asset or index.

"In other words, ETFs are becoming ever more complex and so are more commonplace in the toolbox of professional day traders rather than being low-cost investments for normal investors who like to buy and hold investments. In our opinion there is a risk of increased levels of investor disappointment unless the structures of such ETFs are fully understood."

He advised investors to look particularly closely at commodity ETFs, "leverage and inverse" ETFs and managed ETFs. Commodities ETFs are the most commonly used of these three sectors, tracking either single commodities, such as gold, or a group of commodities. However, some of these are backed not by the commodities, but by derivatives.

The complexity of those derivatives and the continual trading of short-term contracts mean that for long-term investors they can become costly, according to Fotheringham.

"In essence, many ETFs are generally only suitable for short-term traders or for those who understand the commodity markets and products well," he said.

While ETFs are not obliged to use collateral matching the asset or indices being tracked, they have been told to give clearer information about that collateral.

Dow said: "Delve into the small-print and you might find that the collateral backing a FTSE 100 fund is actually made up of, say, Japanese equities. However, transparency is increasing, and firms are becoming more committed to making sure the collateral value matches that of the indices the funds track."

Should all of this deter investors from using ETFs? No, is the consensus, but it does mean that investors should do their homework. Adrian Lowcock, senior investment adviser at Bestinvest, said ETFs offer a huge amount of choice for investors.

But he added a caveat: "As the numbers available increase along with the number of different providers, I think it is getting harder and harder for investors to select an ETF that is suitable for their needs.

"Frequently ETFs are regarded as cheap and lower risk investments, but the latter is totally dependent on the underlying investment and they are not always the cheapest option available," said Lowcock.

As Fotheringham pointed out, not all ETFs act as pure trackers, with a growing number deviating significantly from the underlying investment they follow.

Lowcock said: "In addition, riskier ETFs are coming to the market making it much more complex. For these reasons I believe they require more research and understanding before investing.

"However, on occasion ETFs will be suitable for certain investment opportunities. For example in the US active fund managers were struggling from 2007 until 2010 and ETFs were a cheap way to access the market, although now active managers look more attractive again."c