Tom Stevenson: ETFs have potential to become the next toxic scandal

ETFs are not all they are made out to be. They have been popular over the years however, are not as good as they sound. Liquidity is one of these problems associated with ETFs and is becoming an increasing problem at that as market stress continues to grow.

By Tom Stevenson
3:45PM BST 17 Sep 2011
The Telegraph

Back in April, the Financial Stability Board (FSB), an international super-regulator, wrote a prescient if less than catchily-titled paper "Potential financial stability issues arising from recent trends in Exchange Traded Funds (ETFs)".

Its central warning - that ETFs are not the cheap and transparent vehicles the marketers would have us believe - was spot on. When UBS's $2bn black hole hit the screens on Thursday, no one who read the FSB report was surprised to see the words ETF and rogue trader in the same sentence.

The past ten years have seen an explosion in the popularity of ETFs. In part this reflects some of their acknowledged benefits – relatively low costs and the ability for investors to trade them throughout the day. A third claim, that ETFs are simple products, may once have been true but it no longer holds water. Many of these funds are now fiendishly complicated and way beyond the comprehension of the individual investors and professionals alike who are buying them.

Here are just a few of the reasons why ETFs are not all they are cracked up to be.

First, around half of the ETFs in Europe today do not match the index they are designed to track by holding all of its constituent shares. Unlike the plain vanilla "full replication" ETFs which do, 45pc of the market is in the form of so-called "swap-based" ETFs which instead use derivative agreements, often with investment banks, to simulate the performance of the underlying assets.

Derivative trades add a second layer of uncertainty to the unavoidable ups and downs of the market, the counterparty risk that the organisation on the other side of the contract might go bust. Even worse, the provider of the ETF might sometimes be a part of the same organisation as the derivatives desk carrying out the swap.

When a bank acts in this dual capacity, and because of inadequate disclosure rules, there is a significant potential for a conflict of interest in which the end investor comes off second best. Because there is currently no obligation for the basket of assets used as collateral to actually match the assets the ETF purports to be tracking, a bank may choose to hold less liquid assets to back the fund which it could struggle to sell if too many investors want out at the same time.

The problem of liquidity is an increasing issue with ETFs because of the way in which the funds have branched out into other asset classes such as fixed income and commodities. In these markets, liquidity is typically thinner than in big equity markets such as those measured by the S&P 500 or FTSE 100.

Liquidity is only ever a problem at times of market stress. Unfortunately, that is precisely the time when it matters, as investors in some real-estate unit trusts discovered a few years back when the property market turned down and, funnily enough, their managers were unable to sell enough properties to pay back redeeming unit holders. Investors were locked in.

A big unrecognised risk with ETFs is related to the ease with which traders – hedge funds in particular – are able to use the funds to short markets. For reasons which I'm not sure I could explain even if I had the space, it is possible for the number of shares sold short in an ETF to massively exceed the actual number of shares available. It has been suggested that the "Flash Crash" of May 2010, in which US shares fell 1,000 points before bouncing back in a matter of minutes, was a consequence of this – around 70pc of cancelled trades at the time were reported to be for ETFs.

Like many financial innovations – most obviously, the alphabet soup of mortgage-related debt obligations that triggered the financial crisis – ETFs started out as a good idea, and for some investors, in their most transparent form, they remain so. But, as so often in the financial services industry, a tangled web of complexity has rapidly developed. What was once a straight-forward means of gaining access to a market has turned into a minefield for investors and one which, as UBS discovered in the middle of the night last week, has the potential to become the next toxic scandal.

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