Retail investors are being warned about the risks of exchange traded funds (ETFs), amid concerns that many do not understand that not all products invest in the same way.

The Financial Services Authority said this week that marketing material for ETFs might not fully explain the risks of the funds to investors.

The warning comes as research from the Financial Times shows that ETFs can vary enormously in how good they are at tracking an index, with those in more illiquid markets more likely to have large tracking errors. Even funds tracking the FTSE 100 can have tracking errors of up to 3.45 per cent, data from Morningstar show.

The biggest variations can be found in emerging market ETFs, which are tracking indices that are far more illiquid.

ETFs tracking Chinese indices have tracking errors of up to 18 per cent, while those tracking illiquid markets including Taiwan and South Africa had tracking errors of around 10 per cent. Some are lazy trackers – the PowerShares Hong Kong China fund only rebalances itself once a year.

Swap-based ETFs tend to be better at tracking their index than physical-based ones. This is because they rely on a total return swap contract on the index to get their return and invest the fund in whatever they like, rather than incurring dealing costs by buying and selling stocks in the index they are tracking.

This can be lucrative for providers of swap-based ETFs and some of these extra returns are passed on to investors, reducing the tracking error of the fund.

However, in addition to creating counterparty risk, swap-based ETFs can create transparency problems.

Gary Mairs at TCF Investment says that investment banks that own the ETF providers tend to offload the stocks still on their books overnight into the funds. This can mean that a European ETF could end up holding Japanese stocks. If the Japanese market were to slump and the investment bank were unable to guarantee the total return swap at the same time, investors could lose money. “We think it’s an abuse of the rules and the regulator is asleep on the job on this one,” warns Mairs.

Other ETFs get around the problem of dealing costs by only buying a selection of stocks in the index. While this can reduce dealing costs and even add a level of active management, there could be a large tracking error. The Wilshire Micro Cap ETF, for example, holds some stocks that are not in its benchmark.

To get around these issues, advisers managing client portfolios have a number of checks in place. TCF Investment tries to make sure the counterparty risk of all the ETFs it holds is spread evenly among different institutions.

Haig Bathgate at Turcan Connell says investors should make sure they understand exactly how the return is achieved – whether it is a full replication strategy or swap-based – and what counterparty risks they are exposed to. He also cautions against exchange traded commodities, as these track the futures contracts that predict the price of, say, a metal rather than the physical price of the metal, and these are often not exactly aligned.

Petronella West, director of Investment Quorum, avoids ETFs with high tracking errors in illiquid markets altogether, pointing out that mainstream funds that track big indices have far lower costs.

Copyright The Financial Times Limited 2018. All rights reserved.

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