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."

Compare with the Independent: See how much you could save by switching credit cards. Compare now

Arts & Entertainment
Schwarzenegger winning Mr. Universe 1969
arts + entsCan you guess the celebrity from these British Pathe News clips?
Sport
Raheem Sterling and Luis Suarez celebrate during Liverpool's game with Norwich
football Another hurdle is out of the way for Brendan Rodgers' side
News
Portrait of Queen Elizabeth-II by David Bailey which has been released to mark her 88th birthday
peoplePortrait released to mark monarch's 88th birthday
Life & Style
The writer, Gerda Saunders, with her mother, who also suffered with dementia before her death
healthGerda Saunders on the most formidable effect of her dementia
VIDEO
Sport
Manchester United manager David Moyes looks on during his side's defeat to Everton
footballBaines and Mirallas score against United as Everton keep alive hopes of a top-four finish
News
YouTube clocks up more than a billion users a month
mediaEuropean rival Dailymotion certainly thinks so
Arts & Entertainment
The original design with Charles' face clearly visible, which is on display around the capital
arts + ents The ad shows Prince Charles attired for his coronation in a crown and fur mantle with his mouth covered by a criss-cross of white duct tape
Arts & Entertainment
‘Self-Portrait Worshipping Christ’ (c943-57) by St Dunstan
books How British artists perfected the art of the self-portrait
Sport
Luis Suarez celebrates after scoring in Liverpool's 3-2 win over Norwich
Football Vine shows Suarez writhing in pain before launching counter attack
News
People White House officials refuse to make comment on 275,000 signatures that want Justin Bieber's US visa revoked
News
Sir Cliff Richard is to release his hundredth album at age 72
PEOPLE
Sport
Lukas Podolski celebrates one of his two goals in Arsenal's win over Hull
football
Arts & Entertainment
Quentin Tarantino, director
film
News
The speeding train nearly hit this US politican during a lecture on rail safety
news As the saying goes, you have to practice what you preach
Sport
Mercedes Formula One driver Lewis Hamilton of Britain (front) drives ahead of Red Bull Formula One driver Daniel Ricciardo of Australia during the Chinese F1 Grand Prix at the Shanghai International circuit
sport
Arts & Entertainment
Billie Jean King, who won the women’s Wimbledon title in 1967, when the first colour pictures were broadcast
tv
News
Snow has no plans to step back or reduce his workload
mediaIt's 25 years since Jon Snow first presented Channel 4 News, and his drive shows no sign of diminishing
Life & Style
food + drinkWhat’s not to like?
Finacial products from our partners
Property search
Have you tried new the Independent Digital Edition iPad app?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Database Team Lead ( Leadership, Sybase, Computer Science)

    Negotiable: Harrington Starr: Database Team Lead ( Leadership, Sybase, Compute...

    C#.NET Delphi SQL Developer (C#,DELPHI,SQL)

    £40000 - £50000 per annum + Bonus+Benefits+Package: Harrington Starr: C#.NET D...

    VB.NET SQL Junior-Mid Level Developer (VB.NET,SQL,Excellent com

    £25000 - £35000 per annum + Bonus+Benefits+Package: Harrington Starr: VB.NET S...

    Trade Support, Application Support, Operations Analyst, CRM MS

    £45000 - £55000 per annum + Bonus and Benefits: Harrington Starr: Trade Suppor...

    Day In a Page

    How I brokered a peace deal with Robert Mugabe: Roy Agyemang reveals the delicate diplomacy needed to get Zimbabwe’s President to sit down with the BBC

    How I brokered a peace deal with Robert Mugabe

    Roy Agyemang reveals the delicate diplomacy needed to get Zimbabwe’s President to sit down with the BBC
    Video of British Muslims dancing to Pharrell Williams's hit Happy attacked as 'sinful'

    British Muslims's Happy video attacked as 'sinful'

    The four-minute clip by Honesty Policy has had more than 300,000 hits on YouTube
    Church of England-raised Michael Williams describes the unexpected joys in learning about his family's Jewish faith

    Michael Williams: Do as I do, not as I pray

    Church of England-raised Williams describes the unexpected joys in learning about his family's Jewish faith
    A History of the First World War in 100 moments: A visit to the Front Line by the Prime Minister's wife

    A History of the First World War in 100 moments

    A visit to the Front Line by the Prime Minister's wife
    Comedian Jenny Collier: 'Sexism I experienced on stand-up circuit should be extinct'

    Jenny Collier: 'Sexism on stand-up circuit should be extinct'

    The comedian's appearance at a show on the eve of International Women's Day was cancelled because they had "too many women" on the bill
    Cannes Film Festival: Ken Loach and Mike Leigh to fight it out for the Palme d'Or

    Cannes Film Festival

    Ken Loach and Mike Leigh to fight it out for the Palme d'Or
    The concept album makes surprise top ten return with neolithic opus from Jethro Tull's Ian Anderson

    The concept album makes surprise top ten return

    Neolithic opus from Jethro Tull's Ian Anderson is unexpected success
    Lichen is the surprise new ingredient on fine-dining menus, thanks to our love of Scandinavian and Indian cuisines

    Lichen is surprise new ingredient on fine-dining menus

    Emily Jupp discovers how it can give a unique, smoky flavour to our cooking
    10 best baking books

    10 best baking books

    Planning a spot of baking this bank holiday weekend? From old favourites to new releases, here’s ten cookbooks for you
    Jury still out on Manchester City boss Manuel Pellegrini

    Jury still out on Pellegrini

    Draw with Sunderland raises questions over Manchester City manager's ability to motivate and unify his players
    Ben Stokes: 'Punching lockers isn't way forward'

    Ben Stokes: 'Punching lockers isn't way forward'

    The all-rounder has been hailed as future star after Ashes debut but incident in Caribbean added to doubts about discipline. Jon Culley meets a man looking to control his emotions
    Mark Johnston: First £1 million jackpot spurs him on

    Mark Johnston: First £1 million jackpot spurs him on

    The most prize money ever at an All-Weather race day is up for grabs at Lingfield on Friday, and the record-breaking trainer tells Jon Freeman how times have changed
    Ricky Gervais: 'People are waiting for me to fail. If you think it's awful, then just don't watch it'

    Ricky Gervais: 'People are waiting for me to fail'

    As the second series of his divisive sitcom 'Derek' hits screens, the comedian tells James Rampton why he'll never bow to the critics who habitually circle his work
    Mad Men series 7, TV review: The suits are still sharp, but Don Draper has lost his edge

    Mad Men returns for a final fling

    The suits are still sharp, but Don Draper has lost his edge
    Google finds a lift into space will never get off the ground as there is no material strong enough for a cable from Earth into orbit

    Google finds a lift into space will never get off the ground

    Technology giant’s scientists say there is no material strong enough for a cable from Earth into orbit