The true risk of investing in ETFs

ETF providers that distinguish between physical and synthetic replication ETFs in their literature are misleading investors, according to a study from the Edhec-Risk Institute.

The comments come ahead of the publication of new guidelines for ETFs by the European Securities and Markets Authority.

"It makes little sense to oppose physical replication and synthetic replication products on the one hand, or draw a fine line between unfunded and funded swaps on the other," said the group, part of Edhec Business School.

"Both distinctions are largely irrelevant in practice and convey a false sense of 'comparative' safety. In fact, whatever the replication techniques employed, ETFs are exposed to counterparty risk."

The study says that securities lending is widely practiced by physical replication ETFs and leads to counterparty risk, just as surely as the reliance on over-the-counter derivatives by synthetic replication ETFs.

It recommends that investors should pay more attention to issues that determine the effective mitigation of counterparty risk, such as the level of collateralisation, the quality of the assets that act as collateral, and the ability of the fund to enforce its rights against collateral in the case of default by the counterparty.

"Counterparty risk should be addressed through clear guidelines, and these should apply irrespective of the manner in which counterparty risk is assumed or mitigated, and to all UCITS and competing investment vehicles," the study recommended.

The study also draws attention to the lack of standardisation or mandatory information of tracking error risk today in ETFs.

"In the same way, regulators should give a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes, which remain the main drivers of the financial risks assumed by ETFs."