The ETF innovation challenge

New product structures are emerging to provide a wider range of investment options. But is innovation moving faster than customer education? Emma Cusworth reports

In the world of financial products, the words ‘complexity’ and ‘retail’ do not make good bedfellows. Once the two appear together, a third, ‘regulation’, is never far behind. And so it is with exchange-traded products (ETPs), which have drawn the attention of UK and US regulators, as complexity and retail uptake simultaneously increase.

Despite considerable improvements in transparency and efforts to educate investors, innovation may simply be moving too fast, increasing the scope for misunderstanding or misuse. It could also force regulators to act, potentially to the detriment of the whole market.

Retail use of ETFs has grown markedly: according to figures from Barclays Stockbrokers, the number of client accounts holding ETFs has increased by 137% since 2008 and 42% since 2009. With the Retail Distribution Review (RDR) coming into effect in January 2013, IFAs are widely expected to up their use of low-cost ETPs.

Meanwhile the role of ETFs is changing as they become core, longer-term holdings. Nearly half Barclays Stockbrokers’ clients have their ETF holdings in ISAs and over a tenth in self-invested personal pension accounts. As they increasingly form the beta building blocks in retail portfolios, the importance of investors’ understanding of ETF construction, risks and legal status becomes paramount.

As Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock, said: “It is clearly not the case that all products are the same. Taking gold products as an example, they are generally exchange traded products – ETCs, ETNs or grantor trusts – not ETFs. They might be buying mining stocks, using front or forward month futures or holding the physical gold. Their performance will be different depending on what the underlying assets are and how it is structured.”

She added: “ETPs have moved on a lot. Financial advisers need to be educated and investors need to do their homework.” Rapid innovation presents a considerable challenge to investor understanding. Complexity has massively increased as the range of ETPs expanded in recent years in terms of the asset classes they cover and the structures they employ.

ETF warning
The UK’s FSA has repeatedly pointed to the ETF industry as an area for concern, most recently warning in its Retail Conduct Risk Outlook 2011 that investors may not fully understand the risks underlying ETFs. In the US, the Securities and Exchange Commission has suspended new launches of ETFs making significant investments in derivatives.

Synthetic, swap-based structures have overtaken physical replication as the dominant replication method, increasing the importance for retail investors to fully understand counterparty and collateral risks.

Furthermore, many ETFs listed in London are domiciled in Ireland or Luxembourg and are therefore primarily supervised and protected by those countries’ compensation schemes.

Some experts believe innovation threatens to create another misselling scandal as the scope for misunderstanding and misuse grows.

Terry Smith, founder of Fundsmith and outspoken City commentator, recently said he suspected the average investor incorrectly regards all ETFs as ‘just another form of index fund’. He said they were breaking the ‘golden rule’ by investing in products they didn’t understand, particularly regarding synthetic structures, leveraged and short products.

Misunderstanding, as with any financial product, creates a dislocation between expectation and actual performance.

“In many cases where this has happened with ETFs, the products have not gone wrong,” said Ben Johnson, Morningstar’s director of European ETF research. “They have generally done exactly what they said on the tin, but users have misunderstood how they are supposed to perform. The key to balancing performance and expectation is for investors to peel back the label and make sure they understand what is in the tin.”