Physical ETF counterparty risk underestimated – EDHEC

The counterparty risk of physical ETFs is being underestimated, research by EDHEC-Risk has suggested.

The EDHEC European ETF Survey 2011, which represents a comprehensive survey of 174 European ETF investors, suggested that industry communication on the risks of ETFs has led to the counterparty risk of physical ETFs being underestimated. The survey found that investors think that physical replication is less risky than synthetic replication in terms of counterparty risk.

Investors fail to appreciate the risk of securities lending by physical replication ETFs, against synthetic replication ETFs which do not use securities lending directly. Investors also saw a need for further education to reduce confusion on the difference between highly regulated ETFs and low regulation ETPs.

Other findings of the survey were that the main use of ETFs remains long-term buy-and-hold investing in broad market indices. Investors were also increasingly using ETFs for portfolio expansion and risk management, and continue to see ETFs primarily as passive index-investing products.

The survey showed an increasing demand for ETFs based on alternative-weighted indices, which has risen from 29% to 39% over the past year.

Respondents tended to prefer full replication over sampling replication (where the index is replicated physically with a limited number of securities) or synthetic replication. However, in challenging universes such as illiquid alternative asset classes and broad indices with more than 1,000 constituents there was a clear preference for synthetic ETFs. 63% indicated that they intended to increase their allocation to ETFs in the future. Respondents also intended to increase their investment in futures, while expecting their use of index funds to stay stable on their use of total return swaps to decrease.

The full results of the survey can be read here: EDHEC-Risk European ETF Survey 2011

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