FSA warns advisers don't understand ETF risk

The FSA has expressed its concerns about advisers' understanding of ETFs, as take-up of the products rises in the lead-up to RDR.

The regulator says the warning in its Retail Conduct Risk Outlook (RCRO) paper comes on the back of increased retail use of ETFs and after a rapid change in the product's complexity.

Its disquiet appears to stem from the development of the ETF structure, alluding to the appearance of leveraged and inverse funds, those using active management, and synthetic replication.

The report stops short of identifying any one of these strategies as unsuitable or risky, but refers more vaguely to the challenges of understanding "complex ETFs", compounded by retail investors and advisers lacking familiarity with the products.

The paper also draws attention to the evolution of the exchange-traded brand into ETNs and ETCs, which the FSA says "may be sometimes marketed and perceived by investors as being equivalent to ETFs".

Other complications highlighted include counterparty and collateral risk, as well as the different protection and compensation schemes by which a fund may be covered.

The FSA says: "Since the complexity of ETFs has changed quite quickly and materially it is not clear that retail investors fully understand their underlying risks."

The RCRO has been presented as part of a strategy to identify risks and proactively intervene earlier in the product chain. The FSA says it has heightened its "supervisory vigilance" on ETFs and intends to take action where the sale of "complex ETFs" is producing poor outcomes for customers.

Ronald Paterson, partner at international law firm Eversheds, says this may include requiring companies to take remedial action in relation to sales procedures.  He adds: "The FSA can vary or cancel an authorised firm's permission to carry out regulated activities, prevent a firm from selling a particular product or impose conditions on how a firm sells or markets a particular product."

The regulator's interest comes as a number of wrap platforms in the UK have announced an increased uptake in ETFs from retail investors. This latest risk outlook paper anticipates the implementation of the RDR may "lead to wider adoption of ETFs" and "indirectly increase the promotion of ETFs."