UBS fraud underlines danger of ETFs

The risks inherent in ETFs are once again under the spotlight, this time thanks to the $2bn losses suffered at UBS.

The UBS incident shows that the risks of investing in ETFs “should be regarded as indisputable”, says Terry Smith, founder of fund manager Fundsmith and chief executive of money broker Tullett Prebon.

The facts of the case have not yet been made fully clear, but the UBS employee traded a range of index-related financial instruments including derivatives and ETFs.

The UBS losses come after the European Securities and Markets Authority earlier this year announced it would be revising the rules governing ETFs. In June, the UK’s new super-regulatory body, the Financial Policy Committee, picked out the implications of complexity and innovation arising from the growth in ETFs as key areas of concern.

Richard Reid, head of research at the International Centre for Financial Regulation, said UBS’ loss “will raise many questions both about the systemic risks which might emanate from the growth in ETFs, as well as the effectiveness of the risk control systems implemented since the onset of this financial crisis.”

Smith has been consistently critical of ETFs, in particular how ordinary investors are unaware of the risks involved in buying the instruments. He says: “ETFs are regarded by many investors as the same as index funds. They clearly are not.”

He says: “ETFs are being mis-sold to the retail market. The risks that are being incurred in running, constructing, trading and holding (ETFs) are not sufficiently understood.”

Investors’ perceive ETFs as instruments that simply track a basket of stocks, but some are much more complex. “Some ETFs do not hold physical assets of the sort they seek to track. They are ‘synthetic’ and hold derivatives. This gives rise to a counterparty risk and, as we saw with the UBS incident, some interesting risks within the counterparties supplying the basket of derivatives.”

The UBS trader’s losses could have been much larger. In that case, he suggests, UBS might not have had sufficient capital to perform its duties as a counterparty, and pay out under the terms of the derivatives contract. In that case, Smith says, the ETF would fail.

Smith also says “ETFs do not always match the underlying in the way people expect.” As a result, it is possible for ETF investors to be leveraged long and to lose money if the market goes up, or short and lose it when it goes down.

A further danger is the practice of creating units for the purpose of shorting ETFs, especially in illiquid sectors. Smith says: “There are examples of short interest in ETFs being up to 1,000% short. If the ETF is in an illiquid sector, can you really rely upon creating the units, as you may not be able to buy (or sell) the underlying assets in a sector with limited liquidity?”

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