Many experts believe that, used sensibly, an ETF can be a good choice for investors who don't want to pay expensive management fees. But the UBS scandal has highlighted the importance of understanding these products.
"The good news about ETFs is that you've never had so much choice, and the bad news about ETFs is ... you've never had so much choice," says Justin Urquhart-Stewart, of 7 Investment Management.
So if you're wondering what that means, and what the benefits and risks are, the following should help.
What is an ETF?
The traditional ETF has its roots in a noble cause ? making tracking an index as cheap as possible. Before ETFs came along, the only way in which ordinary individuals could get exposure to the performance of an index, such as the
FTSE 100, was to buy a tracker fund. These often charged a hefty management fee for doing nothing more than replicating the performance of an index. The alternative ? buying enough stock to replicate the index performance yourself - was out of reach to most small investors.
ETFs gave people a cheaper option. They could buy just one stock, listed on a major exchange, that would track the entire market and be relatively easy to buy and sell. Given the advantages, it is no wonder that they have surged in popularity. According to Deutsche Bank, the industry has grown by 40 per cent during the past decade.
Sounds Great. So how did they cause those UBS losses?
It isn't clear that they did. Although Mr Adoboli worked on the Delta One desk, which specialised in Exchange Traded Funds, the UBS statement implies that the problem was that he was pretending he had offset the risks he was taking by recording fictitious ETF trades. That suggests that the problem was not with the structure of the ETFs.
More information should be available as the investigation continues.
Phew. Does that mean that ETFs are ok?
Not exactly. The problem is that, like so many financial products, ETFs started simple and have got more difficult. Whether or not the UBS problem was caused by ETFs, plenty of people, including the Financial Stability Board, have expressed disquiet about them. Even those who champion them and use them regularly, like Mr Urquhart-Stewart, admit there are issues.
"Just like anything, the bankers took something good and made it into something so complicated that no one could understand it," he says.
Around half of the ETFs you can buy now are not what are known as "plain vanilla" ETFs, which hold the stock or commodity that they are supposed to be tracking. Instead, some are ''leveraged ETFs'', which use derivatives. They no longer track an index but seek to return a multiple of the daily performance of that index (for example, if the FTSE 100 rose 2 per cent, the ETF would rise 20 per cent, but if it fell 2 per cent, the ETF would fall 20pc).
Others are commodity ETFs, either called ETCs or CETFs, which aim to track the performance of anything from precious metals to the price of pigs. Although they claim they will replicate the rising or falling price of the commodity, most of them use complex futures, which means their price can vary wildly from the commodity price. These are all called swap-based or ''synthetic'' ETFs.
As well as the danger that this will not simulate the performance of an asset class terribly well, investors have an extra level of risk with a synthetic ETF. Because the provider has contracts with other companies to provide these derivatives, there is a risk that the person on the other side of the contract might go bust. This is called Counterparty Risk.
In the worst case scenario, the provider of your ETF might be part of the same group as the people carrying out the derivatives trade. This is obviously risky, and there's no obligation for the assets used as collateral for the ETF to be the same as the assets it is tracking. If there are problems that could lead to liquidity issues.
"All ETFs carry a risk," warns Adrian Lowcock, of the financial trading group Bestinvest, warning that even with ''vanilla'' ETFs the provider could be lending out the stock that is the collateral for the ETF to someone else. There is a risk that, in a period of market disruption when ETF investors want their money back, managers would be forced to recall such loans, adding to liquidity pressures.
Should I avoid ETFs completely then?
No. The UBS issue is no reason to throw out the baby with the bathwater. "ETFs
are still useful for many investors," says Mr Urquhart-Stewart, whose company uses a variety of them, including the complex ones described above.
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