November 26, 2010 6:45 pm

Investors ‘unaware’ of risks with complex ETFs

Investors are increasingly buying more complex exchange-traded funds (ETFs) that can allow them to hedge their portfolios or magnify returns. But
advisers warn that many are not aware of the
risks that these products can pose.

Sales of ETFs have shot up in the past few years, as private investors have seen them as a way to track markets and sectors at a lower cost. Barclays Stockbrokers says the value of ETFs held in its client accounts has risen 330 per cent since September 2008 – and the products are continuing to grow in popularity.

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Many investors use ETFs simply to track a popular share index, such as the FTSE 100. ETFs have lower costs than other types of funds, with typical total expense ratios (TERs) of 0.5 per cent, compared with 1.5 per cent for an actively managed unit trust.

But more and more investors are buying ETFs that short the market to profit from falling prices, or use leverage to increase potential returns.

In September, the most popular ETF at Barclays Stockbrokers was the ETFS FTSE 100 Super Short Strategy (2x), which accounted for 19 per cent of all purchases. Also in the top 10 ETFs for the month were the db x-trackers FTSE 100 Short and the ETFS FTSE 100 Leveraged (2x).

Barclays Stockbrokers says that only sophisticated investors use such products – often to protect themselves if they are trading on a daily basis.

However, some professional investors avoid these more complicated ETFs altogether. Alan Miller, founder of wealth management firm SCM Private, has never held leveraged or short ETFs, saying that they have much higher costs than the “plain vanilla” variety. This is mainly because they rebalance daily, incurring frequent dealing – unlike
conventional ETFs, some
of which only rebalance once a year.

David Norman of TCF Investment says ETFs that rebalance daily can lose investors a lot of money over just a few days of market volatility. He gives the example of an inverse leveraged ETF that pays two times the inverse of the market but resets itself on a daily basis. If the market goes down 5 per cent, the ETF goes up 10 per cent. But if the market goes up 5 per cent the next day, the ETF price has been reset to 110, so it falls to 99. Even if the ETF price goes up again, investors are starting from a lower base and have lost money.

Some advisers worry that UK investors do not understand these risks. In the US, where private investors are far more likely to have ETFs, the drawbacks to the short and leveraged varieties are better known. Product literature for Deutsche Bank’s db x-trackers says that ETFs on short daily indices are not suitable for investors who want to use them as a buy and hold investment or do not intend to monitor their portfolio on a daily basis. But advisers worry that investors
are not paying enough attention.

“They are not as transparent as everyone would have you believe,” says Andy Parsons of the Share Centre.

The Share Centre recently put a warning up on its online platform for investors who want to
buy short or leveraged products, requiring them to read the list of pitfalls before they take the plunge.

Short or leveraged ETFs also carry counterparty risk, as the products are often swap-based, meaning they use derivative contracts with investment banks to provide their returns. In the case of db x- trackers, for example, counterparty risk is limited to 10 per cent of the investment exposure. But this does not mean that if the counterparty, Deutsche Bank, defaulted, investors would get 90 per cent of their original investment. Instead, they are entitled to 90 per cent of the value of the fund at the time – which could be less than the original investment.

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