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

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.

You could also argue that other product types might have been included. Certain commodity and volatility trackers can also surprise the uninitiated. In 2009, crude oil nearly doubled in price. But trackers that replicate a passive position in oil futures contracts barely budged. Last year people betting on a rebound in equity market volatility (by playing the Vix index) and using ETFs to do it faced an annual cost of 75% purely from rolling the relevant futures contracts. There was nothing underhand here in each case the huge headwind was a by-product of the way the index works.

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This is surely the key message from the FSA's paper: never buy anything you don't understand. You must have a full grasp of what the benchmark your fund tracks actually does before investing your cash. This is more important than ever as ETFs stray into newer and more complex areas.

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