An overview of ETFs is given in Study Session 18, Alternate Investments of the CFA Level I Curriculum. A video regarding what ETFs are has already been posted on the blog. Below is the article written in The Guardian UK, source provided at the bottom, discusses ETFs. Basic understanding of such Funds helps a lot in understanding the terminologies discussed in the article.
Stockbroker Williams De Broë has launched a stinging attack against exchange traded funds (ETFs), calling for regulators to ban the sale of more complex ETFs to retail investors. The broker also warns the proliferation of such funds over the last decade could "severely exacerbate" a market downturn.
ETFs have become a trillion-dollar-plus trading instrument allowing investors to bet on the rise or fall in price of a vast range of commodities, indices and currencies without actually having to buy the assets themselves. But De Broë's head of research, Jim Wood-Smith, said: "ETFs could pose a significant danger to investors at times of high market volatility. We welcome the increased attention regulators are paying to these products, which remain relatively untested."
He is particularly worried by so-called "synthetic" ETFs, which instead of tracking an index such as the FTSE or a basket of commodities, use derivatives to gain exposure, with risks passed on to third parties. Wood-Smith says: "These contracts are not as transparent as we would wish, and there is a danger counterparties could go bust. I am not sure investors realise the risks involved."
Wood-Smith joins veteran trader Terry Smith, head of broker Tullett Prebon, who has compared ETFs to the toxic financial instruments that a played a catastrophic role in the credit crunch, and said the City had failed to learn any lessons.
De Broë has recently stopped selling ETFs to all but the most sophisticated of its private clients. Wood-Smith believes the regulator should step in and ban the sale of some ETFs to private shareholders because many are too opaque.
Some ETFs must sell underlying assets if prices fall by a certain amount, which raises the possibility of a "vicious spiral of programmed selling, with frightening consequences," according to one observer.
Terry Smith said: "ETFs are being mis-sold to the retail market and the risks being incurred in running, constructing, trading and holding them are not sufficiently understood."
And in a blogpost earlier this year entitled "ETFs –you were warned", he said that although many investors regard ETFs as being identical to relatively low-risk index trackers, in reality, many are no more than bets, with hedge funds and banks placing huge bets against ETFs – in some instances 10 times the size of the fund itself. "What if 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," he wrote.
In simple terms, the aim of an ETF is to replicate the performance of a market in a single share. The share tracks a sector, an index, or the price of a commodity or currency, and can offer retail investors exposure to commodities such as gold or oil that they may find difficult to achieve in other ways. The charges are relatively low, but in recent years many ETFs have become increasingly complex.
The newly-established Financial Stability Board, chaired by Bank of England governor Sir Mervyn King, expressed concern about ETFs in an interview with the BBC. King said: "We have said very clearly ... we want the regulator to look carefully at [some types of ETFs] in order to monitor whether certain aspects of this use of the funds invested in ETFs are being directed towards opaque and complex funding structures." The Financial Services Authority is conducting its own review.
Wood-Smith warns: "2012 will be another year of 'spectacular' market moves, driven in part by the increasing influence of ETFs and other similar products. ETFs allow larger and more frequent short-term trading to occur. This can and now does happen in a matter of minutes, rather than days or weeks.
"Regulators talk of attempting to control some of the more esoteric and complex structures behind these funds, but this will not change the nature of the beast."
Before ETFs came along investors who wanted exposure to an index such as the FTSE 100 had to buy a tracker fund, which typically come with high management charges. ETFs allowed people to buy just one share that would track the market and which was easier and cheaper to buy and sell. Deutsche Bank says the $1 trillion industry has grown by 40% since 2001.
Critics say there are fewer problems with plain "vanilla" ETFs that actually own underlying assets. "Synthetic' ETFs are riskier as they often use complex futures or derivatives to track prices that can fluctuate wildly. The ultimate owners of synthetic funds could be hedge funds that might go bust, leaving the investor out of pocket in a worst case scenario.