Smith: ETFs the next mis-selling scandal?

Terry Smith, founder of Fundsmith, warns ETFs face a range of problems from potentially misleading investors to exposing buyers to counterparty risk.

On 11 January I published my first annual letter to the holders of the Fundsmith Equity fund. In it I levelled some criticisms at the investment fad for exchange traded funds (ETFs).

One of my basic concerns was I thought there was a danger of ETFs being mis-sold. I suspect a lot of retail investors think ETFs are the same as index funds. Some of them are, but many are not.

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. It is not hard to give examples in which investors would lose money on a leveraged long ETF if the market went up over a period of significant volatility, or in which they lost money owning a short ETF if the market went down over a period in which there were some sharp rallies. The problem is the daily compounding of ETFs.

Many ETFs do not hold a basket of the underlying securities or assets which they are attempting to track. Instead they hold asset swap agreements with a counterparty (often the bank which is the ETF sponsor) which aim to replicate the performance of the index or asset concerned. There are obvious dangers in such an arrangement in the areas of counterparty risk and collateralisation of the sort which caused so many problems during the credit crisis.

A good example of the potential risks here is given by PEK, the NYSE listed Market Vectors China A Shares ETF. It is illegal for foreign investors other than licensed institutions to buy A shares listed in Shanghai or Shenzhen. So the ETF owns swaps with brokers who are licensed to hold the underlying shares. If PEK owned a significant portion of the float in A shares and its holders tried to liquidate at speed it might be interesting.

Some commentators claim we need not worry much about retail investors misunderstanding ETFs as in Europe at least, they are mainly utilised by institutional investors. This of course misses a couple of vital points. One is that the underlying clients for many of those "institutions" are individual investors - do they really understand the risks their private wealth manager is running with ETFs?

There is also another, and perhaps more pernicious danger, with ETFs than misunderstanding or mis-selling. An ETF is in effect a hybrid vehicle which combines features of an open-ended or mutual fund with those of a closed-end fund. They are like open-ended funds insofar as a purchaser buys or redeems so-called creation units. But they are also tradable in the secondary market, so ostensibly providing real time liquidity.

Secondary trading activity brings with it the possibility market participants will short the ETFs themselves. 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.