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Recently McKinsey suggested that the creation of the ETF structure is the biggest innovation in finance since the development of the mutual fund. Meanwhile, since the recent UBS trading scandal, ETFs are suddenly being treated like toxic waste in the media. This Jekyll and Hyde worldview is confusing to investors, and maintaining a balanced perspective on the merits and risks of ETFs is important.
It’s crucial to understand that the way ETFs are structured in the US and Europe is very different. Here in the US, most index-linked ETFs hold the actual securities in the index that the ETF attempts to track. Leveraged/inverse and many commodity funds are of course the notable exception to this rule. Over 90% of ETF assets in the US are in funds that hold actual securities or physical commodities. By contrast, in Europe almost 50% of all ETFs (by assets) use swap based synthetic replication. Though European UCITS rules limit single counterparty exposure, synthetic replication still exposes investors to counterparty default risk in the event of a systemic shock.

In any case, focusing just on product structure in isolation misses the point – what is more important is whether the product structure is transparent, well understood and clearly communicated to investors. Leveraged ETFs are a good example. The problem with leveraged ETFs is not that they are derivatives-based; rather it is that the details of how they work were not well communicated in the past. Investors didn’t fully understand that these funds use daily rebalancing and compounding. So a 2x fund may not return 2x in relation to the index over a longer time period, even if it does so on a daily basis.

So in what situations should we be concerned about ETFs? In my view it’s problematic when fund managers launch products that sacrifice the best attributes of ETFs. The features that have driven the popularity of ETFs are tradability, transparency, simplicity and lower costs. The danger for ETFs in the future is that fund managers will jump on the tradability bandwagon and fail to deliver on the latter attributes. Many of the recent funds launched have been more complex (e.g. market neutral ETFs) compared to the more traditional ETFs that gave very targeted exposure to a specific asset class or factor. However these types of complex funds still account for a small percentage of ETF assets. In the midst of the current ETF bashing it’s worth keeping in perspective that the vast majority of ETFs in the US are still low cost, tradable and transparent products that could serve investors well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: In Defense Of Most ETFs