Is your ETF a safe bet?

Europe's exchange-traded fund (ETF) market has grown quickly for one main reason: value. Many investors have switched to ETFs from poor-value actively managed funds, or from bank-issued structured products that may contain several layers of costs and risks.

But ETFs also have potential conflicts of interest between issuer and investor. In a surprisingly frank research report (given that the authors' employer is one of the main European issuers), Deutsche Bank strategists Christos Costandinides and Daniel Arnold have estimated that the managers of ETFs can earn double their funds' fees through so-called "ancillary" activities. Broadly speaking, issuers of "synthetic" ETFs make money on the side from trading, while issuers of "physical" ETFs do so from lending out their funds' underlying shares and bonds.

In some cases, the trading relationship between a bank and a synthetic ETF issued by a subsidiary of the same bank may involve the bank providing the ETFwith lower-quality collateral than the index the fund is tracking. In other words, the ETF may be providing the parent bank with cheaper funding than it could otherwise raise against this collateral.

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In a physical ETF, shares are typically lent out (to a short seller, for example), with the resulting revenues split between the fund's investors and the ETF manager. Sounds fair but the investors bear all of the risk if anything goes wrong. These aren't the only potential conflicts of interest (for example, the index that the ETF is tracking may be calculated by a related company), but arguably they're the key ones. So what can you do about it?

Before you choose an ETF, check how transparent the manager is being about the revenue-generating activities it's involved in on the side. If it's a synthetic ETF, does the ETF issuer update daily on the fund's collateral, so investors can see if not easily analyse what their fund is actually holding? And for ETFs that lend their underlying shares, how much information does the manager offer on this, and what's the "fee split" between manager and investor? Second, who's on the fund board and how is governance exercised? In many European countries, there's no requirement for a board to have a majority of independent directors. So open the prospectus, look at who's on the board and see how well equipped they are to represent your interests.

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