The contrarian investor - Are ETFs working?

The FT's David Stevenson urges advisers to carry out proper due diligence on the vehicles

Let us start with the subject of lending out shares in an ETF. It makes the managers extra money, which they use to cut costs, but in times of crisis the practice could blow up in our faces. If a major issuer of a mainstream FTSE 100 lent out a large chunk of their portfolio of blue chips to a sole external outfit like an hedge fund and that hedge fund froze up, guess what could happen to your ETF? It would implode.

Those shares lent out are the firm's net asset value, yet the administrators of a defaulting counterparty might not give two hoots about your claim on your assets. This prompts the next question - collateralisation. Many ETFs are not buying the basket of shares you thought you were buying. The big investment banks will chunder on about over-collateralisation (tendering 110% of the value of the assets) but I bet your investors would like to know what they are actually investing in.

Which brings me to the guys and gals who do know - namely those clever investment bankers who structure the stuff. One lady from a leading French bank at this event exemplified what really terrifies me. She was trying to succinctly explain how an ETF could be structured but then introduced a term called 'optimisation for dividends'.

Imagine buying a French main-market tracker that receives a big chunk of money on a regular basis from its blue chips. Under French tax law, the state with-holds a large bit of that but optimisation allows the bankers to shift those payments to a German entity where tax on dividends are lower, thus releasing more money for investors. It is a noble aim and one to applaud, but I bet they do not mention this in their IFA presentations.

Last but by no means least, this story demonstrates the tax issues. It is fiendishly complex stuff and rumours are circulating in the market that one major provider has a hugely successful index-tracking fund structured in such a way that any gains could actually trigger income tax not CGT. Maybe the rumours are wrong, but a stack of legal advisers and other fund managers I have been talking to think the opposite. Fancy explaining to your client why the have been hit with a massive income tax bill?

My point is not to denigrate ETFs - these issues also affect structured products and mainstream fund managers and wealth managers who use passives.The issue here is that alongside research on the asset class and the index, due diligence over fund structures is a really, really important issue and we cannot rely on the regulators to be one step ahead.

David Stevenson is a Financial Times columnist and consultant. E-mail him at davidcstevenson@gmail.com