Simon Read: Understand the risks before choosing ETFs

Exchange Traded Funds are sold as a low-cost way to invest in a wide range of different investments. They are similar to tracker funds in that they are passive investments. But problems are beginning to be voiced about just what the underlying investments are, and are they safe.

The Financial Stability Board published a paper this week highlighting the dangers. The problem, according to the FSB, is the complexity of some of the funds. Some use swap agreements with counterparties which agree to provide a return that matches the underlying asset class or the index that the ETF is seeking to track.

That's effectively all about protecting the investment, but we know from recent experience that counterparty risk can lead to massive problems if the counterparty defaults. It's what led to the downfall of Lehman Brothers, and UK investors in Keydata also experienced a collapse and losses because of counterparty risk that proved unsafe.

That doesn't mean that ETFs are unsafe. But it does mean that some complex funds may not be suitable for average investors. As ETFs become more popular, more of us are likely to be exposed to funds that are really only suitable for professional investors who are paid to take and understand risks.

Returns on some of these look hugely attractive. There's a silver ETF, for instance, that's climbed 93.2 per cent in a year, but at the same time a leveraged silver ETF has soared 289 per cent. I was alerted to these while chatting this week to financial planner Kevin Deamer of KMD Private Wealth Management. "This level of performance could attract retail investors to leveraged funds, which would be dangerous," he told me. "I doubt many IFAs or wealth managers feel competent enough to recommend these, so investors should stay away, well away."

It's a timely warning. Would you invest in a hedge fund? If not, avoid the riskier ETFs. The key is to understand what you're investing in and if you don't, avoid it. At the same time the industry must help by making ETFs more transparent.

Cheques may yet be getting a reprieve. The Treasury Select Committee said this week it was reopening its inquiry into the future of cheques "as a result of continuing public concern over plans to abolish them by 2018".

Personally I haven't used a cheque for years, but am aware that millions of people do still do so. Small businesses in particular are reliant on them. Until the banking industry finds an acceptable alternative, then the paper payments should not be scrapped. I'm glad that people power has forced the Treasury to think again.

s.read@independent.co.uk

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