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Exchange traded funds (ETFs) have quickly become a trillion-dollar plus trading instrument - but there are warnings that they are now are being mis-sold to the retail market
Small investors have been mis-sold "exchange traded funds" at the heart of UBS's £1.3bn rogue trading loss and face potentially huge losses, according to leading City financier Terry Smith.
Smith, chief executive of money brokers Tullett Prebon, compared ETFs to the toxic instruments that played a catastrophic role in the credit crunch, and said the City had failed to learn any lessons.
"I have long thought and written that there is a certainty that ETFs are being mis-sold to the retail market and that the risks that are being incurred in running, constructing, trading and holding them are not sufficiently understood. After the UBS incident I think this should be regarded as indisputable."
Exchange traded funds have in a remarkably brief space of time become a trillion-dollar plus trading instrument, with speculators using them as a cheap way to bet on the rise or fall in price of a vast range of indices, currencies and commodities from the FTSE 100 through to gold and even 'leveraged live cattle'. As much as half of the trades in gold are now driven by ETFs, while some critics blame them for speculatively driving up food prices.
In a blog entitled "ETFs - You were warned" Smith this morning said that too many investors regard ETFs as identical to relatively low-risk index trackers. But in reality, many are 'synthetic' and expose the investor to a counter party risk. He said hedge funds and investment banks are at times taking huge short positions in ETF, in some instances 10 times the size of the ETF itself.
"What if (when?) such ETF trades cause such a mammoth loss in a counterparty which does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer-the ETF will fail."
Terry Smith first rang the alarm bell on ETFs in January this year. He compared them to the CDOs and CLOs (collateralised debt and loan obligations) from the "alphabet soup of toxic assets" in the credit crisis, and this morning added that the companies selling ETFs "clearly do not understand the product they are peddling, and if they can't what chance has the retail investor got?"
In June, the UK's new Financial Policy Committee (FPC) voiced fears about the increasing popularity of ETFs, which it warned were shrouded in "opacity and complexity". It said it was concerned that ETFs "could become a source of risk to the system as the market evolves".
The biggest seller of ETFs in the UK (and the world) is iShares, a unit of Blackrock, the world's largest investment manager. It has issued $600bn (£380bn) worth of ETFs, and as recently as two days ago launched its latest ETF product, the "iShares Markit iBoxx $ High Yield Capped Bond" which allows investors to speculate in junk bonds.
David Gardner, head of distribution and marketing for iShares, said: "At iShares it is business as usual. The majority of ETFs are not synthetic but backed by physical assets." He added that iShares always made it clear to investors at point of sale whether the ETF is synthetic or physical.
Some synthetic ETF providers have just one counter-party or sole swap provider, but Gardner said that iShares always diversifies risk by having a number of different underwriters and are "multi-collateralised". He added that iShares simply acts as a manufacturer of ETF products, and does not engage in proprietary trading in ETFs.
However, the UBS incident is likely to prompt a tougher approach by regulators towards the ETF market. Dr Richard Reid, head of research at the International Centre for Financial Regulation, said: "It is probably early enough in the growth of these funds to be able to say that they do not represent a truly systemic risk although this latest episode will be seen as a real warning signal."
He added: "For some time now there have been some voices in the industry raising concerns, particularly about the number of new vehicles. Regulators, conscious of the pressure they are under to consider ways of heading off systemic risks to financial stability, will be keen to think about what steps they should be taking now to supervise this market segment."
Patrick Collinson
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