The rising popularity of ETFs

Investors and financial advisers alike are pouring increasing amounts of money into exchange traded products.

New ones seem to appear weekly and assets under management are growing at providers such as ETF Securities, Deutsche Bank (products trade as db x-trackers) and Barclays Global Investors (iShares).

If the UK market takes on US proportions it could turn into a flood: there 70 per cent of the market is retail, here it is 30 per cent, the rest being institutional. QQQQ, the ubiquitous exchange traded fund (ETF) tracking the Nasdaq 100 index claims net assets worth more than $16bn.

Andy Parsons, Advice Team Manager at The Share Centre says exchange traded products such as ETFs and ETCs (exchange traded commodities) deserve to be considered given their low expense ratios when compared with actively and passively managed funds, and ability to open up interesting areas in which to invest. Performance for those willing to take risk this year has been particularly strong in areas such as precious metals and emerging markets.

Financial Express data shows the Jersey domiciled dollar denominated ETF Securities Leveraged Silver ETC returned 182 per cent in sterling terms in the 12 months to 16 November.

The Lyxor Brazil ETF which tracks the Ibovespa index gained 142 per cent over the same period.

However, not all the products work the same way and investor education is critical. It is telling that the providers mentioned all stress educational material on their websites explaining counterparty risk.

When US investment bank Lehman Brothers went bust last year and insurance giant AIG looked like going the same way it threw doubt over the exchange traded product market for precisely this reason. If the counterparty goes bust, as Lehmans did, there is a threat to the product.

Justine Fearns, of IFA AWD Chase de Vere, says: "Investors very much need to be aware of counterparty risk, particularly for ETCs, which could make them less attractive for inclusion in portfolios."

Providers point out that there are certain ways in which counterparty risk is being controlled. For example, ETFs that are structured under the EU UCITS III rules (Undertakings for Collective Investments in Transferable Securities) would work to a specific 10 per cent limit to counterparty exposure via the OTC market. If a fund were liquidated under UCITS investors should get 90 per cent of the net asset value at the time of the liquidation.

Mark Weeks, chief executive of ETF Securities, points out that counterparty risk may still exist even where swaps are not involved, across different generations of products.

"For example, shares tracking an index are lent out at (often at substantial fees). The risk comes if they are lent out to the likes of Lehmans. Sufficient collateral is required to cover any potential losses. This collateral is either non-cash or cash, which in turn raises issues of risk associated with cash reinvestment."

The second generation, or swap backed model with a single counterparty, comes with issues of cost associated with the swap, which is "not obviously transparent to the investor."

"Relying on a single swap counterparty also carries a risk. There is an argument that if it is fully collateralised it is safe, but if for example there is a big intraday movement and the bank that is the swap provider goes bust the investor could end up with an intraday loss. Applying UCITS may provide some succor, but the question then is how long it may take to get back assets."

"The third generation relies on a minimum of two swaps providers to spread the risk. But this model could still be hit by a similar intraday problem to second generation products. The benefit is that if one swaps provider goes bust, the other can step in. In theory it should work."

However, these points about risk should not overshadow the potential benefits to the investor. The key is not only to understand what the product invests in, but also what risks there may be if counterparties are involved.

This article first appeared in the Daily Telegraph