Do your homework on ETFs

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).

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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 www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.