Be prepared to make the most of ETFs

published 3 May 2011

Exchange-traded funds (ETFs) are under attack. In mid-April the global financial system's top three regulators (the G20 Financial Stability Board, the International Monetary Fund (IMF) and the Bank for International Settlements) all spoke out about what they see as a dangerous trend towards rising complexity in the ETF market, potential conflicts of interest in the way ETF ranges are operated, and the systemic risks that ETFs might pose to the broader financial market.

Let's address these concerns in turn. The argument that ETFs are becoming too complex is not new. From their beginnings as tradeable tracker funds, based on a few well-known benchmarks, ETFs have moved to cover a very broad range of asset classes: commodity futures, equity index volatility, credit default swaps you get the idea. The solution is easy as we've pointed out in the past: understand what you're investing in. Before you buy an ETF, look at how the underlying benchmark is put together, how its weightings are determined and, most importantly, what costs might arise from the way it is built. It makes no sense to switch to a notionally cheaper tracker, only to pay out multiples of your fee savings on hidden index costs.

Potential conflicts of interest are more complex. Those highlighted include ETF ranges being used by banks to raise cheap financing for their trading activities; ETFs' underlying stocks being lent out to benefit the fund company; and potential worries over objectivity when the ETF provider also calculates the index. It's hard for an investor to do much about the first two, but on the last, we'd suggest you insist on an independent index provider and check that several independent market makers are there to support an ETF's liquidity.

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Finally, what of systemic risk? Regulators worry about what they call the "shadow banking system", which could include newer financial products such as ETFs. They're also concerned that investors may see ETFs as more liquid than they really are. On this point, remember the markets accessed by ETFs vary widely in their underlying liquidity. Some are highly liquid major stock indices, gold, gilts, US Treasuries others are not. Be aware of this when selecting and trading funds, and you shouldn't go far wrong. In short, there are potential pitfalls with ETFs, as with any other investment product but by making sure you know what you're buying, you can avoid them.

Paul is a multi-award-winning journalist, currently an editor at New Money Review. He has contributed an array of money titles such as MoneyWeek, Financial Times, Financial News, The Times, Investment and Thomson Reuters. Paul is certified in investment management by CFA UK and he can speak more than five languages including English, French, Russian and Ukrainian. On MoneyWeek, Paul writes about funds such as ETFs and the stock market.