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Are Irish ETFs safe?

Investment | Trackers Helpful? 14

Asked by BernieB, submitted 20 November 2010.

Open Quote Everyone writes how efficient, cheap and sensible ETFs are but no one ever seems to write about how safe and secure they are. Probably the most popular, iShares run by Blackrock, are domiciled in Dublin. I assume they are not covered by the FSA Compensation Scheme. Are they at risk if the Irish economy continues to melt down? ( I don't just mean ones tracking the Irish economy!)End Quote

Answered by Justin on 23 November 2010

You're right, iShares exchange traded funds (ETFs) are not covered by the Financial Services Compensation Scheme (FSCS) due to them being domiciled in Ireland rather than the UK. This means that in the very unlikely event your money vanishes (for a reason other than poor investment performance) you won't be entitled to any compensation.

So what are the risks?

Well, the most obvious is that someone runs off with your money. Fortunately investment funds, including ETFs, must place fund assets with a third party, called a 'custodian'. Custodians, usually large banks, must ring fence the money/assets to ensure they're held for the benefit of investors in the fund and no-one else. This means that iShares, for example, can't take money from its funds (other than agreed charges) for its own use. If the custodian goes bust your money should still be safe as its held in a separate 'segregated' account, independent of the bank's own money - although there's no guarantee.

A potentially bigger risk is where an ETF uses an investment bank to provide the index tracking - so-called 'counterparty' risk.

When an ETF tracks an index it will generally either buy all the shares that comprise the Index (e.g. iShares FTSE 100 ETF) or agree a deal with a third party who'll provide the tracking, called a 'swap-based' or 'synthetic' ETF (e.g. ETFS Energy DJ-UBSCI). In the case of the former the fund owns the underlying shares so should be safe in the scheme of things. In the latter case the fund is relying on a third party ('counterparty') to provide the returns, if the counterparty goes bust the fund could lose money (this happened when Lehman Brothers, a popular counterparty, bit the dust).

However, there are some provisos re: counterparty risk. Under fund (UCITS III) rules counterparty risk can be no more than 10% of the fund value. So if the worst happens it will hurt, but shouldn't be a disaster. Secondly, some ETFs hold extra assets (called 'collateral') to compensate for counter-party risk, reducing the likelihood of losing money if a counter party defaults.

You should find details of the custodian, counterparties and collateral levels (if relevant) in an ETF's prospectus, so take a look before investing to ensure you're comfortable.

Does the dire state of Irish finances pose additional risk to ETFs domiciled in Dublin?

I suppose it could if the custodian or counterparty is an Irish Bank, as if the bank goes bust there is a small risk you could lose money. iShares uses 'The Governor and Company of the Bank or Ireland' as custodian on its Dublin ETFs, which gives slight cause for concern. However, as the chances of the EU allowing an Irish Bank to go bust seem pretty much zilch, I wouldn't lose sleep over it.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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