The case against exchange traded funds (ETFs) is growing, and even if you have not put money into them there are good reasons to sit up and notice. The fear is that, once again, investment managers and banks are ignoring risk in the heady pursuit of profits - and that poses a threat to us all.
ETFs began to make a splash on the UK investment scene a few years ago. At the time the schemes, which operate much in the same way as tracker funds, were highly praised for their simplicity and low costs. But over the past year, fears have grown that they have become too clever for their own good.
The Bank of England became the latest body to add its voice to these concerns in its Financial Stability Report at the end of last month. Then last week, Evercore Pan-Asset, an investment firm, said that it would exclude more complex ETFs from the majority of its portfolios.
To give you a bit of background, there are two types of ETF — physical and synthetic. A physical ETF buys most, if not all, of the shares in the underlying index. With a synthetic ETF, the fund uses a type of financial instrument called a derivative to replicate the index, and it is this second synthetic type which has got regulators worried.
With synthetic ETFs, providers enter into a “swap” agreement with a counter-party, such as an investment bank, that promises to provide a return that matches the index. This “financial engineering” gives rise to the risk that the firm with which the ETF provider has the contract will default.
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But there is a further worry. The collateral holdings put up as security for the swap deal mean that the underlying portfolio of the ETF may bear little resemblance to the index it is meant to track. You might think you are investing in the US stock market but could be holding shares in Japan and the emerging markets. This means that if there is a default investors could be left holding collateral that bears little resemblance to the assets they understood they were exposed to.
This all sounds painfully familiar. One of the lessons of the financial crisis was that investment bankers can become dazzled by the beauty of financially complex structures. These opaque and tortuous creations seem a great idea when the going is good but crumble quickly when things get tough, spreading contagion. The dazzle seems to be back raising the question of whether the seeds of the next crisis could be contained in the growing complexity of ETFs.
Providers of synthetic ETFs say they are being unfairly treated as scapegoats. They point out that conventional funds use derivatives, and they do not disclose their collateral holdings. They have a point and it is true to say that some ETF providers have taken steps to make their products more transparent. It is also worth pointing out that ETFs are still largely owned by institutions not retail investors.
However, the risks should not be ignored. ETF providers and investment bankers should listen to the criticism - unfortunately listening is not something that investment bankers have proved good at in the past.