Why we should fear ETFs' huge contribution to bank profits

Fundsmith CEO Terry Smith was a vocal critic of ETFs last year.

He is still convinced many of the vehicles, especially synthetic ETFs, are being mis-sold and wants better labelling for the products. 

Here he gives his latest views on the ETF industry and in particular his concern about the percentage of banks' profits generated by the these investments.

"Last year I warned about the perils of ETFs. This was followed by warnings from amongst others, the Bank of England, the Financial Services Authority, the International Monetary Fund and the US Securities and Exchange Commission in a rare example of closing the door on a stable which may still contain a horse.

"Since regulators have come in for so much criticism of their loose handling of the financial sector prior to the credit crisis it would be churlish to criticize them for these warnings, and foolish to ignore them.

"One more problem with ETFs became apparent to me in the course of this debate. ETFs are represented as low cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks. This seems counterintuitive: how does a low cost product become a major profit contributor?

"The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to "clip the ticket" of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides.

"They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury.

"My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets. But if you decide this is correct, buy precisely that, an index fund, not an ETF.

"The only difference between a physical ETF (which frankly is the only sort you should contemplate unless you like the risk of synthetic derivative swaps with counterparty risk) and an index fund is that the ETF is traded on the market as the term "Exchange Traded" implies.

"Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds.

"The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don't want active management, and mostly you shouldn't, buy an index fund."