Industry viewpoint: Is the FSA correct over ETFs?

Joanne Young asks a panel of industry experts: Is the FSA’s Retail Conduct Risk Outlook paper right on ETF complexity?

Andrew Whiteley, managing director at Provisio    
It seems the FSA was trying to differentiate between physically replicated ETFs and all other ETPs, because of the risk involved with using counterparties. We err towards full replication for all our clients, simply because it gives the greatest level of security and is more straightforward to explain.  

Some of the db x-trackers ETFs though are 100% collateralised. That collateral might not necessarily match the ETF, but that poses a different risk and one the FSA has not grasped yet. But most ETF providers value their collateral on a daily basis, so if it has gone down in value they have to increase the levels. 

Having considered it further, the paper was also focusing on leveraged products and others which I am not sure retail investors would consider using. I do think there is a use for derivative-based products in the retail space, but certainly I agree leveraged ETFs are far too complicated for retail.

The other issue, which is more pertinent to the retail sector, comes in ETCs that are effectively tracking futures prices instead of spot prices – not many IFAs understand that, let alone retail investors. There is risk, but there is risk everywhere. I think structured products are more of an issue, and not just in terms of counterparty risk. The paper was a little bit unfair and a little bit vague, in that it failed to reach any specific conclusions.

The FSA pushed ETFs right to the fore for the IFA community and I think that was done without really understanding that these products are fundamentally a bit more risky than others because they are not covered by the Financial Services Compensation Scheme. The FSA opened Pandora’s box and I now get the impression they are trying to push the lid back down. 

David Brunning, director at Brunning Newman Houghton
The FSA are right to raise concerns, because a number of advisers have treated ETFs as being identical to unit trusts and Oeics. Basic, non-geared ETFs are entirely suitable for retail clients, but I have my concerns about the others.

Any type of fund where there is a degree of leverage, or forward pricing, or use of options, should be considered a sophisticated investment, and identified and treated as such. Equally, using synthetic replication for non-sophisticated retail clients is a risk. There are a number of advisers out there, forced to consider ETFs because of the RDR, who might themselves not understand synthetic replication. 

There are two aspects to risk; that to capital and that of misunderstanding.  The FSA tends to take the approach of looking at a product like a geared, synthetic oil ETF, which will be both complex and high risk, but it does not follow that just because something is more complicated it poses a greater risk to capital.