Is the FSA right on the risks of ETFs?

Joanne Young asks the industry: 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, and 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 they have to increase the levels. 

Having read a bit further, it 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 it was done without really understanding that these products are fundamentally a bit more risky than others because they are not covered by the FSCS. They opened Pandora’s box and I now get the impression they are trying to push the lid back down. 

Christopher Aldous, chief executive at Evercore Pan-Asset
The FSA’s paper was interesting and it has caused quite a furore because, despite being only about a page and a half long, it is quite a wide-ranging comment. I do think there is an argument for redefining ETPs into simple and complex – that is something we try to do anyway when we refer to specific funds. It is true the average investor does not appreciate the nuances that exist across the “exchange-traded” universe. 

The problem is ETFs have transformed into something complex and risky, but it is a pity that the FSA has tarred all ETPs with the same brush. It has clearly endeavoured not to, but people inevitably pick up on the headline when they are looking at such a generalised, short piece. 

I do not agree that synthetic ETFs are any more risky than physical or optimised ETFs. The issue is really with liquidity – exchange-traded counts for nothing if the underlying assets are illiquid. The synthetic funds we use are over-collateralised, so do not carry that counterparty risk, and the most annoying part of this report is it fails to make that differentiation. 

The FSA is trying to do too much in a short space, although it is quite right to highlight the risks of inverse and geared ETFs. I regard some of the uncollateralised ETNs as remarkably high risk. Unfortunately, it is a slightly lazy bit of commentary, and the FSA really needs to focus in and define which ETFs are good for the retail sector, which are complex, which are risky, and give advice. 

My concern is once the regulator raises the question, IFAs start worrying about whether they should be using ETFs, despite the fact these products provide some fantastic solutions for retail investors. 

Thomas Becket, chief investment officer at PSigma Investment Management
Whether in ETFs or structured products, a lot of the products currently being marketed are not suitable for retail investors, and that is bordering on the irresponsible. I absolutely think the FSA should be strict with both industries. 
The only ETFs I would recommend for retail investors if they want an index are those that are fully replicated.

I think synthetic replication is fine for professional investors, but I would hazard a guess that most retail investors will not know what they are buying. A lot of people buying into leveraged ETFs will not understand the complexity with which these funds work behind the scenes. 

Advisers themselves are not particularly aware of the differences between ETNs and ETCs, so there needs to be a process of education and examination before people should be allowed to make investment decisions based on that. I think retail clients are at risk of being exposed to a lack of understanding. 

I think this discussion might be a symptom of an industry that is accelerating and growing too fast. The development of the ETF market and the fact that IFAs and investors are increasingly amenable to them has been seen as a green light for investment banks to make money. That very rapid pickup in interest is something the FSA is right to be looking at.