Should you avoid exchange traded funds?

Terry Smith's words carry weight. So when Smith, chief executive of broker Tullett Prebon and partner in a new fund management venture, Fundsmith, launched an attack on exchange-traded funds (ETFs) recently, his views drew a lot of attention. ETFs, said Smith, are "worse than I thought": they carry counterparty and collateral risks (we'll explain this in a moment); there's a risk of mis-selling if they are too complex; and they may involve very high levels of short-selling, incurring little-understood structural risks.

What should the average investor make of it all? Smith certainly has a point on the complexity of some funds we've regularly talked here about the need to understand the index you're buying. Leveraged funds have caused problems for investors who didn't understand the mechanism of daily compounding this means that the ETFs' performance diverges from the underlying index over time, and makes such ETFs only suitable for short-term trades. Meanwhile, ETFs tracking commodity indices are highly dependent on the futures markets, rather than on the price movements of the underlying raw materials.

As for the counterparty and collateral risks in ETFs, these undoubtedly exist. Most European ETFs either lend shares to boost returns or use swaps to track their indices. In both cases there's some risk exposure if a counterparty (the party borrowing shares or on the other side of the swap) goes bust, even if that risk is reduced by the fund using collateral. However, many actively managed funds also loan out shares or trade in derivatives it's not unique to ETFs. While it's by no means perfect, the disclosure by ETF operators of their funds' securities lending and derivatives activities is much better than that of most active fund managers.

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What about the short-selling argument? This takes us into a very arcane area of finance, but in my view, because an ETF's shares in issue can expand or contract to match investor demand, there shouldn't be a structural problem if lots of investors are shorting a specific fund (because more shares can be created to meet demand). The fact is, ETFs aren't as simple as they may seem at first, but neither are most active managers worth what you pay for them (which is the reason for the growing popularity of passive funds). As we've said before, make sure you understand how a fund works before buying, and you shouldn't go too far wrong.

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