Terry Smith: ETFs - you were warned!

The losses of $2bn incurred by an allegedly rogue trader on the Delta One desk at UBS have again raised the subject of the (lack of) risk controls by banks dealing in opaque instruments, the need to separate investment and retail banking and the risks inherent in ETFs, says Terry Smith, chief executive of Fundsmith.

I have written over the past year about the unappreciated risks in ETFs and it is probably time to bring these thoughts up to date.

ETFs are regarded by many investors as the same as index funds. They clearly are not:

1. Some ETFs do not hold physical assets of the sort they seek to track.

They are "synthetic" and hold derivatives. This gives rise to a counterparty risk, and as we saw with the UBS incident, some interesting risks within the counterparties supplying the basket of derivatives.

What if (when?) such ETF trades cause such a mammoth loss in a counterparty which does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer-the ETF will fail.

2. ETFs do NOT always match the underlying in the way people expect.

Because of daily rebalancing and compounding, you can own a leveraged long ETF and lose money over period when the market goes up but during which there are some sharp falls.

Equally, you can own an inverse ETF (which provides a short exposure) during a period when the market goes down but there are some sharp rallies and lose money.

This actually occurred with some inverse ETFs in 2008. I would strongly suggest that people would not expect to be leveraged long and lose money if the market goes up or short and lose it when it goes down.

3. Because you can exchange trade these funds, they are used by hedge funds and banks to take positions and they can short them.

Because they can apparently rely upon creating the units to deliver on their short, there are examples of short interest in ETFs being up to 1000% short i.e. some market participant(s) are short 10 times the amount of the ETF.

If the ETF is in an illiquid sector, can you really rely upon creating the units as you may not be able to buy (or sell) the underlying assets in a sector with limited liquidity?

In the past week I am told there have been examples of the cost of borrowing (the cost of borrowing stock to deliver on a short sale until such time as you close the short by buying back) up to 14% p.a. on the IWM ETF (the iShares Russell 200 Index ETF).

Now why would someone pay 14% p.a. to borrow something in what is more or less a zero interest rate environment and when you should be able to deliver the underlying securities to create unlimited units in the ETF.

The answer I suspect is that the short sellers cannot create the units because the ETF operates in an area with limited liquidity (the Russell 200 is the US small cap stock index).

The danger of allowing short sales which are a multiple of the value of a fund in an area where it may not be possible to close the trades by buying back the stocks are clear, but amazingly, during the debate in which I have been engaged by various cheer leaders for ETFs, they have claimed that there is no such risk in shorting ETFs.

They clearly do not understand the product they are peddling, and if they can't what chance has the retail investor got?

4. Although ETFs are billed as low cost they are also the most profitable asset management product for a number of providers. How can this apparent contradiction be so?

The answer is that the charge for managing the ETF is only one part of he cost. There are also the hidden costs in the synthetic and derivative trades which the provider undertakes for the ETF.

As a result of all this I have long thought and written that there is a certainty that ETFs are being mis-sold to the retail market and that the risks that are being incurred in running, constructing, trading and holding them are not sufficiently understood.

After the UBS incident I think this should be regarded as indisputable.