Terry Smith attacks 'pernicious danger' of ETFs

Fundsmith founder and manager Terry Smith has warned of the "pernicious danger" underlying ETFs, months after labelling the product an “investment fad” that investors misunderstand.

In his blog, entitled ETFs - Worse than I thought, Smith reiterated his earlier concerns that retail investors will assume ETFs are synonymous with index funds and in particular fail to understand the implications of leveraged and short strategies.

He also claimed synthetic replication entails "obvious dangers" as regards counterparty risk and collateralisation, warning "it might be interesting" if investors in a swap-based fund tried to liquidate their positions at speed.

Smith added: "There is another and perhaps more pernicious danger with ETFs than misunderstanding or mis-selling."

He said this danger is market makers shorting. Smith argued that because there are no limits on short-selling ETFs, an investor could be buying shares in a fund from a short-seller, where no new shares have been created.

He also questioned what short interest "really represents" in funds such as Market Vectors China A-shares ETF, where it is illegal to short the underlying.

Smith added: "The scope for a short squeeze is tremendous."

Smith's blog comes weeks after a number of reports from international regulators expressing concerns over the growth of the ETF industry.

Smith did not reference any of these, but his anxiety over the "breakneck" pace of development within the market follows a similar theme.