Do your homework on ETFs

New guidelines have been drawn up to protect consumers of financial products such as exchange-traded funds (ETFs). But it's still vital you do your research, says Paul Amery.

Since 2008, regulators have aimed to take a tougher stance on protecting consumers of financial products. "More intensive supervision" and "a more aggressive approach to enforcement" are promised by Britain's Financial Services Authority (FSA), for example.

Unfortunately, when it gets down to the nitty-gritty of product detail, it's not easy to draw a line between financial products that are "non-complex", and so suitable for sale to retail investors on an execution-only basis, and those that are complex enough to require a financial adviser's assistance, or a demonstrably greater level of sophistication in the client.

Last week, for example, Europe's securities market regulator, ESMA, released new draft guidelines for the exchange-traded fund (ETF) market. In contrast to regulators in other parts of the world, including Hong Kong and the US, it decided not to distinguish between ETFs that use derivatives to track their indices (synthetic ETFs) and those that buy the underlying index stocks (physical ETFs).

That's because doing so in Europe would mean rethinking the so-called UCITS rules. Under these rules, retail mutual funds (including ETFs) are allowed to use derivatives within certain limits. There seems to be little appetite in Brussels to dismantle a brand that's proved highly popular with investors.

In any case, a simplistic distinction between supposedly risky synthetic ETFs and safe physical ones wouldn't have made sense. Both types can use financial engineering techniques, such as collateral swaps or securities lending, which can boost returns, but also add risk.

Also, ESMA is proposing new rules for collateral management, the maintenance of secondary market liquidity (putting the onus on issuers to ensure investors can sell even when markets are stressed) and the disclosure of the underlying index's methodology and constituents.

These steps should all help to improve market practices. But in the meantime, investors still need to do their homework. Although disclosures of fund collateral (the assets backing the fund) have improved, investors could still suffer a hit if a bank counterparty fails.

The more complex indices underlying certain ETFs also offer plenty of scope for large hidden fees to be embedded. Secondary market liquidity varies widely (smaller or more obscure ETFs tend to be worse for this). Do your due diligence in all these areas before committing to buy any ETF.

Paul Amery edits , the top source of news and analyses on Europe's ETF and index-fund market.

Most Popular

Three companies that are reaping the rewards of investment
Share tips

Three companies that are reaping the rewards of investment

Professional investor Edward Wielechowski of the Odyssean Investment Trust highlights three stocks that have have invested well – and are able to deal…
19 Jul 2021
The future belongs to emerging markets – three EM stocks to buy now
Share tips

The future belongs to emerging markets – three EM stocks to buy now

Professional investor Carlos von Hardenberg of Mobius Capital Partners picks three of his favourite emerging-market stocks.
5 Jul 2021
Commodity supercycle or not, here’s a metal that’ll still be in demand – tin
Industrial metals

Commodity supercycle or not, here’s a metal that’ll still be in demand – tin

Commodity prices may have come off the boil recently. But for tin, the only way is up. Dominic Frisby picks the best ways to invest.
7 Jul 2021