Don't be fooled by the simplicity of exchange traded funds

The UBS fiasco should serve as a warning on ETF's complexity. Chiara Cavaglieri and Julian Knight report

For most investors, a rogue trader may seem a remote piece of City objet d'art.

They bet the farm on a highly complex investment gamble and lose big time. Huge sums are lost and a banker shamed, but after a few days the story disappears and investors carry on as before.

But the alleged actions of Kweku Abodoli, who may have lost investment bank UBS $2bn through rogue trading, could hit much closer to home, because Mr Abodoli seems to have been using an investment vehicle that everyday investors and pension fund managers have been encouraged to put their money into, exchange traded funds (ETFs).

ETFs are supposed to offer the best of all worlds – simplicity, ease of access and cheap to buy and sell. In their most basic form ETFs allow investors to track a particular index of shares or commodity market. So when prices rise your investment grows and when they fall the opposite occurs.

They have proved highly popular with pension fund managers and everyday private investors. You may not even realise it but you may have quite a bit of your retirement fund or rainy-day money invested in an ETF. And that could be a major problem now that regulators including the Bank of England, Serious Fraud Office and the Financial Services Authority (FSA) have already voiced their concerns that some investors may not understand all the risks involved.

"On the surface they are so simple, but underneath they can be a nightmare," says Ben Seager-Scott, a senior analyst at investment advisers Bestinvest.

Before exchange-traded investments came along, if you wanted exposure on an index, the only option was a tracker fund. This meant digging deep to cover a management fee despite the fund merely mirroring the performance of an index.

Today, however, ETFs can be highly sophisticated and that's where potential problems can arise. There are different types of ETF: "physical" ETFs, which hold stocks in the index being tracked, and "synthetic" ETFs which use complex derivative agreements backed by an investment bank.

With synthetic ETFs there is potentially less risk of tracking errors because the return is based on a contract, not the actual holdings. But investors face the additional risk of involvement from another company, the investment bank.

Experts are far less concerned about physical ETFs because they own real assets, but with synthetic ETFs, if the counterparty goes under, the contracts become worthless – and the downfall of Lehman Brothers taught us in 2008 remember the danger of counterparty risk.

Terry Smith, the chief executive of fund management group Fundsmith, has long been campaigning for greater transparency, warning that the sector is in danger of becoming the latest mis-selling scandal. "ETFs do not always match the underlying investment in the way people expect," he said. "You can own an ETF and lose money over a period when the market goes up but during which there are some sharp falls."

Despite these problems, many advisers insist they remain a good option for investors. And although, like any investment product, they will not be suitable for all investors, they do have many important benefits.

First, they can be traded on the stock market easily and cheaply. Even investors with a small portfolio can use ETFs to achieve exposure to a huge range of assets. The average ETF fees are only one-third of the typical unit trust, leading to significant savings over time and only stockbrokers' dealing charges to factor in. For people who want to spice up their portfolios with more exotic investments, ETFs are the ideal and often only option.

"For larger, more diverse portfolios, exchange traded investments can offer more sophisticated investors access to areas in which it would otherwise be difficult to invest, such as gold, livestock or agriculture and markets, such as South Africa and Kuwait," says Danny Cox of Hargreaves Lansdown.

However, the old investment rule always applies – you must know exactly what you are getting into, and if you don't, the message is to steer clear. First of all, you need to be sure that you are investing in a fund, not a note. So, while ETFs are UCITS III compliant funds, under which rules limit counterparty exposure in these funds to 10 per cent – so investors can lose only a 10th of their cash regardless of whether the counterparty folds – with exchange traded notes (ETNs), everything could potentially be lost.

"Collateral rules, if any, will simply be established on a fund-by-fund basis with ETNs," says Mr Seager-Scott. But, more generally, he sees ETFs as expanding investor choice. He says: "Overall they have allowed investors to access a much wider range of assets than would have been the case before their advent."

With ETFs at least 90 per cent covered by collateral, and the fact that UBS has pointed out that investors have not lost money as a result of the recent scandal should give other ETF investors some peace of mind. What's more there are regulatory measures in place to protect investors in ETFs. However the UBS scandal should still serve as a warning that complicated products such as synthetic ETFs are inherently risky.

The UBS fiasco is likely to force the hand of regulators that are already twitchy and it may be better for nervous investors to sit tight until greater regulation comes into play. In the meantime, to minimise risk, those keen on ETFs should either stick to physically backed funds or ensure that if they are putting their money into synthetic funds, the providers are highly transparent and have a number of underwriters in place.

"As with any investment it is important to understand exactly what you are buying," says Mr Cox. "If you are unsure, seek advice. Speak to your stockbroker or an independent financial adviser."

Expert View

Ben Seager-Scott, Bestinvest

"ETFs provide investors with a low-cost method of tracking an index. The apparent simplicity belies deeper complexity and in this regard not all ETFs are equal. It's important for people to do their homework on these funds before investing. Most important, to my mind, is ensuring that any counterparty risk is over-collateralised – in other words, you have more than enough security, held by a third party, to protect against investment banks screwing up."

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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