Investors urged to check they understand ETFs

Investors are being urged to check that they understand the structure of exchange-traded funds (ETFs), following warnings that the products could pose “systemic risk”.

Concerns over the transparency of so-called swap based ETFs, which do not hold stocks in the index they are tracking, were raised this week by the Financial Stability Board (FSB), the International Monetary Fund and the Bank for International Settlements.

The FSB, which overseas global regulators, says ETFs could pose a risk if they are hit by requests for redemptions in the event of a market sell-off.

It suggests regulators should keep a close eye on the ETF market, which is still in its early stages in Europe, and learn lessons from the past.

“What’s important to us is that the product evolves in a stable way so we avoid accidents we’ve had with other financial innovations, like securitisations prior to the crisis,” an FSB spokesperson explains.

The FSB was particularly concerned about swap-based ETFs, which rely on a swap contract with a counterparty bank to meet the return due to investors.

Such products may hold stocks as collateral for the swap that are unrelated to the index they track – which the FSB says could introduce illiquidity risks.

“One of the things you expect from collateral is for it to be reasonably liquid for the ETF provider to meet redemptions if they occur – but there are some signs that this may not always be the case,” the FSB says. The UK’s Financial Services Authority warned in February that investors might not understand that swap-based ETFs exposed them to collateral and counterparty risk.

The FSB says that questions needed to be raised as to whether investors had enough information about the collateral that their ETFs held.

David Norman at TCF Investment points out that there was also a lack of transparency in some actively-managed funds, such as absolute return funds, which also use stock lending and swaps to deliver returns.

“Innovation is running at a very fast pace in the market so investors need to be on their toes,” he warns. But he adds: “There are some excellent value, transparent products issued by strong providers with a proven record so we should be careful not to throw the baby out with the bath water.”

iShares, owned by Blackrock, says that its swap-based ETFs use a variety of counterparties, but that it
is “looking to further enhance disclosure where we feel it adds value for our clients”.

The FSB has also raised concerns about “plain vanilla” ETFs, which do not use a swap to meet their investment return but instead hold a basket of underlying securities.

But they can lend out most of this stock, which the FSB says could also pose liquidity risk in the case of requests for redemptions. It believes one possible solution is a cap on securities lending for ETFs.

“If we continue to see that the industry is not paying attention to the calls for caution, it may become necessary to take action,” it says.

At present, ETFs in Europe are more commonly sold to institutions, whereas the US has a strong retail market. But asset managers in the UK such Blackrock and Credit Suisse are now targeting sales of ETFs at private investors, who are becoming increasingly cost-

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