ETF risk – a personal action plan

Global regulators lining up to beat on Exchange Traded Funds (ETFs) has been an unnerving experience for passive investors, not least yours truly. A number of potential risks have been highlighted and – given the shortage of decent passive investing alternatives available in the UK – it would be a grievous blow if ETFs prove to be about safe as a cluster bomb in a playschool.

While warnings about the counterparty risks and conflicts of interest that bedevil synthetic ETFs sired by investment banks are not exactly new, it did come as a jolt to learn that physical ETFs share many of the same problems.

What’s more, the reports are long on scary ‘what if’ scenarios but short on suggestions for practical action that retail investors might take.

So while the wheels of global regulation grind into gear, here’s my action plan. Bear in mind, this is a personal response that suits my investment needs and attitudes. I offer it purely as a discussion point, not as fail-safe, portfolio bomb-proofing.

Who knows whether the current clouds of uncertainty will drift away, turn more threatening, or eventually transform into golden rays of investor-friendly enlightenment? Until then I’m going to…

Favour index funds

Index funds are like the slower country cousins of ETFs. They’re simpler, and only like to trade once a day in the afternoons. The expectation of intra-day liquidity does not burden these investment bumpkins, and they’re sturdy physical, security-holding folk, not synthetic replicants fresh from the lab.

True, index funds can lend securities but, crucially, they’ve been around since 1975 without blowing up. Sure, the past is not a guide to future performance, but it’s the best clue we’ve got.

The basic asset classes can all be held very cheaply in index funds without worrying about trading costs and a passive investor can create a well-diversified portfolio without recourse to ETFs, especially if you use Vanguard funds.

Use physical ETFs rather than synthetics

I will still use ETFs to access broad asset classes that are not catered for by index funds.

In the UK, that means I need to buy ETFs to cover commodities, property, value, and UK small cap.

Where I have a choice, and the cost differential isn’t too great, I’ll choose physical ETFs over synthetics.

With most of my assets in index funds, I can accept the potential risk of using a more complex vehicle to gain exposure to a few extra asset classes – especially as the main risk highlighted for physical ETFs is the potential fallout from security lending during a market apocalypse. The world and his financial services’ mother lends securities, so it’s difficult to protect myself from this particular spectre by choosing some other type of investment vehicle.

You can check how the ETF is structured on its factsheet or web page. Variations on physical replication are:

• Physical
• Full
• Sample
• Optimised

If it says ‘synthetic’ or ‘swap-based’, then it’s not a physical ETF.

• Major physical ETF providers include iShares and HSBC. Credit Suisse also offers a reasonable scattering.

• Db X-trackers, Lyxor and ETF Securities generally, if not always, stock synthetics.

iShares currently discloses the most information by far about its security lending activities, although it hardly arrives in easy-to-digest form. In the future, investor-friendly presentation of the facts will be my tie-breaker for individual ETF selection.

An alternative approach favoured by Monevator co-author The Investor is to use fairly low-cost investment trusts. If you’re looking for reliability borne out by history, then investment trusts have been around since 1868. They’re actively managed but some have relatively reasonable TERs, and The Investor has done an excellent job of explaining the foibles to watch out for.

The last resort: Synthetic ETFs

Synthetic ETFs could be a flashpoint for global financial contagion in extreme market conditions, according to those regulator warnings.

It’s important to stress the reports cited potential risks rather than cast-iron certainties. They called for further investigation, they didn’t pass a damning verdict. All the same, the regulators are clearly unhappy at the current level of ETF operational transparency.

My attitude to synthetics is a trickle-down version of my physical ETF outlook. In the index tracker food-chain, synthetic ETFs are:

1. More complex
2. Therefore more risky

However they are useful for reaching otherwise inaccessible asset classes cheaply. Therefore I’ll buy them as long as I:

1. Have no other suitable choice
2. Keep their use to a minimum
3. Diversify among providers

I currently hold one synthetic ETF, which is worth less than 10% of my portfolio. I’m comfortable with that as there’s no other way for me to track that asset class.

I also console myself that it will have to be a pretty cold day in hell before the envisaged nightmare scenario occurs. It’s not impossible, but my exposure to a malfunctioning ETF is minuscule in comparison to the damage plunging markets would do.

What’s in the basket?

The G20’s Financial Stability Board (FSB) report proposes:

In particular [ETF providers] should make publicly available detailed frequent information about product composition and risk characteristics, including on collateral baskets and arrangements for synthetic ETFs.

Due diligence for investors would then include checking the counterparty viability and collateral quality that underwrites the synthetic ETF.

The swifter industry operators already post some of this information about individual ETFs on their websites:

Those that do:

• db X-trackers
• iShares
• Credit Suisse

Those that don’t:

• Lyxor ETF
• ETF Securities

I’d rate the information they provide as nigh on useless to the average punter in its current form. Even if you can competently analyse the quality of potentially hundreds of securities held as collateral, it changes on a daily basis.

Frankly disclosure is not the answer here. Only a tightening of regulations that govern the quality of collateral will do.

We can’t spend our days squinting at a spreadsheet of Japanese small caps, or whatever else the investment bank has put up behind its synthetic ETF. What we need is the assurance that the ETF is backed by an adequate amount of high-quality, liquid collateral that can be shifted sharpish in an emergency.

Reputation counts

Conflicts of interest are a major theme within the recent ETF risk reports. They raise the question of whether investment banks use their synthetic ETFs as a dumpster for illiquid collateral, and as a source of cheap funding.

In the conflict of interest stakes, private investors versus investment banks equals easy meat for the banks.

In the shadow of the credit crunch, I’d argue trusting big banks is like trusting a python to babysit your pet mouse. If I can choose an ETF from anyone other than a big bank then I will. That’s easier said than done, though, as subsidiaries of the banks dominate the synthetic ETF market.

Tried and tested

So that is how I plan to deal with the situation for now, until the industry and/or the regulators make the risks of ETFs plainer.

In truth, this has always been my tracker selection policy anyway. But the regulators’ warnings have helped to ram home how carefully I should tread in the face of rampant financial innovation.

It’s best to stick to the tried and tested, and when it comes to asset classes, to the broadest, deepest end of the pool. There’s no real need to go sticking my nose in the glowing sludge that collects at the fringes.

Take it steady,

The Accumulator