Funds: Don't buy what you don't understand

With exchange traded funds (ETFs) straying into newer and more complex areas, the FSA recently decreed leveraged ETFs as generally unsuitable for the average retail investor. The clear message is never to buy anything you don't understand. Paul Amery reports.

Last week the Financial Services Authority (FSA) issued a new discussion paper entitled 'Product Intervention'. In it, the FSA lumped leveraged exchange-traded funds (ETFs) in a single high-risk category with "complicated structured products" and "traded life policy investments", classifying all three as generally unsuitable for the average retail investor. As we've noted before here, the performance of a leveraged ETF, which typically promises twice or three times the daily (positive or negative) return on an index, will diverge over time from the same multiple of the index return. This is due to the daily rebalancing that leveraged ETFs undergo (for more on how this works, see here).

The trouble is, the FSA will have a job on its hands if it plans to take a proscriptive stance in deciding exactly which retail investment products are or are not suitable for consumers. Its initial list seems arbitrary and lacking in a common theme: leveraged ETFs tend to be highly liquid (easy to trade) but can cause problems if you don't understand how the rebalancing occurs. By contrast, complex structured products and traded endowment policies are dangerous because pricing tends to be opaque; they often give you full counter-party risk exposure to the issuer; and there is usually a limited secondary market, or none at all.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free
https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up
Paul Amery

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.