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The ETF risks you ought to know

Investment | Trackers

By Justin Modray, published 04 May 2011.
Helpful? 35

Exchange traded funds (ETFs) have soared in popularity, but should you be concerned about their 'hidden' potential risks?

ETFs are big business and, in general, a great idea. They provide a low cost way to track a dizzying number of indices across assets including stock markets, fixed interest, commodities and property. And because they're traded on stock markets buying and selling is both fast and simple.

However, there are a couple of risks (aside from the tracked index falling) that you should be aware of. Graeme mentioned these is his recent article, so I thought I'd further explain so you can gauge the risks for yourself.

Apologies if you find this a bit long-winded and technical, but that's unfortunately just the way it is. I'll try and explain things as clearly as I can!

Synthetic ETF risk

There are basically two ways an ETF can track an index. It can either buy the physical underlying stocks (often called 'securities') or buy a piece of paper from another financial company that promises to pay the index returns (called a 'swap').

When an ETF buys underlying securities it should be pretty safe. For example, a FTSE 100 tracker would buy shares in all the FTSE 100 companies and then give them to a third party custodian (usually a large bank) to look after. If the ETF provider goes bust your fund should be unaffected as the shares are still safely held by the custodian.

ETFs that use swaps are tracking the index synthetically, as they're using promises on bits of paper rather than physical securities to provide index returns. Nothing wrong with this per se, but you're now relying on another financial company honouring their promise in order to receive the index returns - this is called counterparty risk.

Synthetic ETFs must, under EU law, limit this risk to 10% of the fund per counterparty. They might do this by using lots of different counterparties and/or ask counterparties to stump up some security (called 'collateral') to protect against them breaking their promise. For example, an ETF using one counterparty would need to get collateral of at least 90% of the fund's value to ensure it meets the 10% counterparty risk rule.

Collateral is a good idea, but there's a risk that if it needs to be used it won't be worth as much as expected. That's because the collateral doesn't have to be the same securities as the index being tracked. So a synthetic FTSE 100 ETF could theoretically hold shares in small companies or junk bonds as collateral - stuff that might prove hard to shift in a hurry at the price assumed by the ETF in its collateral calculations.

Stock lending risk

ETFs that buy physical securities can still suffer counterparty risk if they decide to lend some of their securities to someone else. Why would they do this? Simple...to earn more cash.

Lots of financial institutions like to borrow stocks as it can help them profit if prices fall. For example, a bank might borrow stock from an ETF, sell it straight away on the market, then later buy back the same stock (hopefully at a lower price to make a profit) when it's due to return the stock to the ETF. In return for borrowing the stock, the bank will pay the ETF a fee.

ETF managers generally split this fee about 50/50 with the fund itself (i.e. investors) - iShares splits it 60/40 in favour of investors.

This doesn't sound a bad idea, but what happens if the counterparty doesn't return the borrowed stock? Well, as per above the ETF would normally hold collateral to limit counterparty risk within the rules, but in a worst case scenario you could lose up to 10% per counterparty - possibly more if the collateral ends up being worth less than the ETF expected.

The extent ETFs lend securities varies between funds, it could typically range from zero to more than a quarter of the fund. The revenues from securities lending will obviously vary accordingly, but when used heavily could add a percent or more to annual fund performance.

Securities lending is not a bad thing, lots of funds (not just ETFs) do it. The key is to understand the extent and to whom a fund lends stock, how much money it receives in return, the split of lending revenue between the fund/manager and the amount/quality of collateral is held.

Once again, not all this information is readily available, if at all. iShares, which offers more physical securities (rather than synthetic) ETFs than most, publishes securities lending revenues in the annual report & accounts for its funds and lists some (outdated) figures on the extent of lending and collateral held in a brochure targeted at large intuitional investors.

This is better than most, but still falls short and is nigh on impossible to find for a typical private investor.

Wot no compensation scheme?

A big incentive for trying to gauge the counterparty risks mentioned above is that ETFs are not covered by the Financial Services Compensation Scheme (FSCS) and rarely covered by equivalent overseas schemes. So if a counterparty failure ends up losing you money I'm afraid you'll have to take the hit.

Conclusion

Now before you get too scared, let's put all this into context. Counterparties tend to be large banks that very seldom go bust. Yes, Lehman Brothers was a very big counterparty and did go bust, but while we can never say never the likelihood of something similar happening is low.

And even if a counterparty does go bust then no more than 10% of an ETF should be exposed, although it could be more if the collateral held turns out to be toxic hence difficult to sell.

The issue for investors is being able to sensibly gauge these risks. ETF providers tend to tuck away basic collateral and securities lending information, assuming they even publish it, and counterparty information is often scant - in my view a major failing that the regulators should address.

These potential risks don't make ETFs bad, I will continue to use to both physical and synthetic ETFs for exposure to indices that are otherwise difficult to track. But they do mean it's sensible to browse an ETF's prospectus before investing to get a clearer idea of whether it tracks the index physically or synthetically, the counterparties, whether it lends stock and, if so, what cut the fund will receive.

We can live in hope that ETF providers are one day forced to clearly display this information on fund factsheets, including a summary of any collateral held.

Oh...and tax

If you're still awake then a final thing to think about is tax. ETFs are based offshore which means that gains could be taxed as income if the fund hasn't attained either reporting or distributor status. Take a look at my answer to this question for full details.

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Readers' Comments (1) - To post a comment please register or login .


Comment by justin at 9:00pm on 07 Jun 2011:

If you want to read some really serious (but informative) ETF information take a look at www.etfstall.co.uk. It's run by Francis Groves, who's also written a book on the subject - not light reading but well worth a visit if you want to delve deeper into ETFs.