Who is afraid of exchange-traded funds?

In many markets around the world, exchange-traded funds (ETFs) are increasingly becoming a threat to the status quo of ‘old-school’ fund managers.

In many markets around the world, exchange-traded funds (ETFs) are increasingly becoming a threat to the status quo of ‘old-school’ fund managers.

However, the so-called dangers of ETFs are, in reality, much less about the product, as some would have you believe, but more about the impact on the long established fund management industry.

There have been five principle criticisms levelled at ETFs:

1) Counterparty risk.

There are two types of ETF in the UK, those that own the underlying constituents of the index and those where a third party guarantees the index return in exchange for a collection of assets (collateral).

In the case of the physical ETFs, they often lend out stocks whereby the fund receives some of the associated income and the borrower posts collateral.

In these examples the disclosures are terrible, because investors do not know how much is lent or the exact collateral deposited.

However, this is an investment industry wide problem, with many unit trusts similarly lending out their investors holdings without full disclosure.

The maximum regulatory counter party risk for a synthetic ETFs is 10%, but in practice many of the largest providers over collaterise (they post more than 100% collateral).

There are strict rules governing what is allowed in this context. Also, you can see the quality of the collateral, because it is often shown daily.

For example, one major provider posts collateral in the form of T Bills and cash.

2) Transparency.

Investors do not know what they are getting. This is another common criticism. However, the facts are the exact opposite. An ETF clearly shows which index it tracks and the constituents of the index.

Investors can see 100% of what is held either directly (in physical ETFs) or indirectly (in synthetic ETFs).

By comparison, our analysis of 28,167 European mutual funds shows they have just 48% transparency (interestingly, higher than the 40% figure for the UK unit trust industry).

3) Short selling.

The criticism here is that if an ETF was to become huge, compared to its underlying market, it mightbecome illiquid.

This is true, except that most of the largest ETFs follow very large liquid indexes and are comparatively small. The same issue applies to unit trusts.

If you invest in a small company unit trust and everyone wanted to sell, it would probably be impossible, and the fund would have to be suspended.

At least the ETF would have a dealing price which you might not like but you could accept or reject.

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