Just how risky are ETFs?

Exchange-traded funds (ETFs) have received a fair bit of bad press recently. Concerns tend to focus on synthetic' funds that use derivatives to track an underlying index or asset. As a result, cash flows into ETFs this year have favoured those that use physical replication ie, they own the index's underlying stocks.

However, buyers should be aware that many physical ETFs then go on to lend' out these stocks to earn extra income, taking collateral in return. This is known as securities lending'. In the case of the iShares FTSE 100 ETF, for example, this means that some of the top 100 UK companies owned by the fund are being temporarily replaced by other stocks Nike, Newmont Mining and Wells Fargo are currently the top three collateral holdings, according to the issuer's website.

What are the risks in doing this? The main one arises if the borrower fails to return the index stocks. The ETF issuer may then have to sell the collateral to compensate. But because the collateral is different from the index stocks, there could end up being a shortfall in the amount raised. So, as an extra insurance policy, collateral levels are typically set at over 100% of the value of the stocks lent.

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The involvement by ETFs in these sorts of deals can be justified. ETFs are passive holders of index stocks, so if there are extra returns to be generated from lending, then they might as well earn them. On the other hand, there's no free lunch in investing, so if you can make a return from lending, then there must be risks present too. Moreover, while the fund manager typically gets a share of the revenues from lending, it's the fund investor who bears all of the risks.

Such risks are not specific to ETFs. Securities lending is common practice among managers of active funds too. Indeed, regulators have historically encouraged the practice as a way to iron out temporary market imbalances, thus ensuring liquidity. But recently there's been pressure to raise transparency in what's a very opaque area of the market.

So while there's nothing necessarily wrong with stock lending, you should favour ETFs that are transparent about lending policies and fair about sharing out the returns from lending fees.

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