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ETFs' breakneck growth makes them an accident waiting to happen

Exchange-traded funds | ETFs breakneck growth makes them an accident waiting to happen Ian Fraser

Terry Smith, the pugnacious founder of London-based asset management group Fundsmith, has launched a broadside at the exchange-traded funds sector, arguing that it is an accident waiting to happen for investors and asking whose neck(s) will get broken as a result of its “breakneck” growth.

Smith is a City of London veteran famous for his 1992 book Accounting for Growth, a no-holds-barred assault on the accounting deceit practised by "Big four" accountancy firms and the UK's entire financial establishment - a book that cost him his job as head of research at UBS (formerly brokers Phillips & Drew) and led to substantive reforms led by the Accounting Standards Board's Sir David Tweedie.

Writing in his recently launched blog Smith has found a new target. He has warned that ETFs - a fund type that has experienced phenomenal growth in recent years - are being mis-sold to retail investors. He also suggested that low levels of understanding among investors of the fund class could easily lead to disaster. Smith said, “In particular, the performance of short ETFs and leveraged ETFs may diverge markedly from what an investor who believes they are simply index funds would expect.”

Here's a bit of background to ETFs. They are passive, index-trackers which, unlike mutual funds, can be traded on bourses. This means that, as with ordinary stocks and shares, their prices fluctuate on an intra-day basis; investors can buy and sell at any time during trading hours; they are tax-efficient; and perhaps most importantly, have comparatively low management fees. Investors can do anything with ETFs that they can do with ordinary stocks or shares, including the short-selling of particular ones.

In a recent article in the Financial Times, Gillian Tett warned the ETF sector may be entering bubble territory:

[The sector] is currently in the grip of a wave of investor enthusiasm that risks turning a fundamentally sensible innovation bad … the FSB calculates, for example, that by the third quarter of 2010 the ETF sector had $1,200bn of assets, after growing at an average annual rate of 40% in the past decade.

Smith pointed out that ETFs don't track as well as they claim to do, that they are are frequently mis-sold and that “synthetic” ETFs, ones that don't actually hold the underlying assets but instead hold derivatives of these assets, are subject to collateral and counterparty risks of which investors are rarely aware. He wrote that “there are obvious dangers in such an arrangement in the areas of counterparty risk and collateralization of the sort which caused so many problems during the credit crisis."

This issue was highlighted by the Financial Stability Board and Izabella Kaminska of FT Alphaville in April. The FSB report called for much greater levels of transparency from ETF providers, adding:

"ETF providers and investors should review the risk management strategies of ETFs, especially in areas such as counterparty risk and collateral management, as well as assessing their exposure to market and funding liquidity risks."

Smith said the “most pernicious danger” is that most investors buying ETFs are going in with their eyes closed, oblivious to risks such as the unlimited scope offered for shorting-selling in the sector.

“In an ordinary equity, the short-selling is limited by the ability of the short sellers to borrow the stock so that they can deliver it to complete their sell bargains. In an ETF a short seller can always rely on the process of creating shares in the ETF to ensure he can deliver.

“This leads to the possibility that a buyer of an ETF share is buying from a short seller and that no new share has yet been created. The investors who buy from the short sellers don’t own a claim on the underlying basket of securities or swap in the ETF, they own a promise to deliver the ETF share given by the short-seller."

I can't imagine why but this point reminded me of my recent blog post on the views of Professor Laurence Kotlikoff - “The financial system is a Ponzi scheme that could collapse at any time”.

“The problem [is] the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest. This is a significant problem given reports that there has been short-selling up to levels of 1000% short in some ETFs … The scope for a short squeeze is tremendous.

"The net result is that across the entire ETF asset class portion of the funds which ETF purchasers think have been invested in ETFs, via the creation of new shares, has in effect been lent to hedge funds. The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do.

"Perhaps these little understood structural issues explain why 70% of the cancelled trades in last May’s Flash Crash were in ETFs when ETFs represent only 11% of the securities in issue in the US."

Further reading on exchange-traded funds:

Tags: asset management , exchange-traded funds , fund management , hedge funds , retail investor , short selling
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