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The surge in exchange-traded funds (ETFs), exchange-traded notes (ETNs) and related products was a sign of flow into the passive industry management. Unable to outperform the markets, index trackers are packaged and sold to the public with the bonus of daily liquidity. But what are exactly these products?

A 2009 ETF conference in Amsterdam proved to be informative and included interesting participants with conflicting opinions on important matters such as counterparty risk and settlements and regulations which left the audience confused and troubled. ETFs are essentially passive funds, designed to track the movements of an index. Some ETFs are physically-backed, that is, they hold the underlying investment which they are supposed to be tracking, whereas the majority of ETFs use synthetic (swap-based) replication to facilitate their exposure. ETFs have many inherent risks and as they become more complex and blurry, the intrinsic risks become less obvious. In addition to the market risks that any ETF investor is exposed to, there are other inherent structural risks in this exponentially spreading instrument:

Counterparty risk

In the case of swap-based ETFs, the ETF provider enters into swap contracts with other financial institutions rather than obtaining direct exposure to the target index. Under UCITS III regulations, ETFs have to be at least 90 per cent covered by collateral; theoretically this means that there is only a 10 per cent counterparty risk with another provider. Nevertheless, the ETF can fail if the ETF trades cause a huge loss in a counterparty that does not have sufficient capital to cover that loss and honor the derivative contract. On top of that, the swap contracts between a synthetic ETF provider and an investment bank are constructed in a "black box", making it virtually impossible to understand how the target returns are delivered.

But, are physically-backed ETFs safer? They might have been if the majority of the providers did not practice securities lending, the process of lending securities to a third party in exchange for a fee. The type and quality of collateral requested from borrowers in these transactions can and does vary to the extent that the fund can end up facing major liquidity issues during a financial crisis. Securities lending can result in huge losses occurring if the borrower defaults.

Tracking error risk

Providing extra protection to investors frequently results in additional costs. This is reflected in the performance of the ETF in the form of a negative tracking difference between the return of the underlying index and that of the ETF. Many, if not most, of the ETFs optimize their basket to replicate the benchmark index they are supposed to be tracking. As such, these ETFs obviously display greater tracking error risk when volatility spikes. ETF performance does not, therefore, always match the underlying index. As a result of daily rebalancing and compounding, the leveraged and short ETFs can sometimes fail to adequately track their index and can miss sharp rallies or can aggravate falls in the corresponding index.

Spread gap risk

The liquidity of ETFs is a serious and separate issue from the liquidity of the underlying shares. The trading spread gap can vary between 10 to 50 bps depending on the chosen ETF provider. Considering that investors rush into this type of instrument in order to trade a specific index instead of investing in a mutual fund, most investors find themselves negatively surprised at the cost they incur when executing their trades.

Settlement risk

The UBS scandal in September 2011 which reported losses of $2.3 billion is an ideal example of this type of risk. The UBS trader involved in September 2011 scandal was capable of establishing fake transactions in UBS's system to disguise his exposure largely because of the weak trade settlement rules in existence in the London market and the fact that many counterparties do not automatically request trade confirmations. In addition, the bank's risk controllers failed to check the huge trading positions that were reported as hedges and their subsequent margin calls.

Despite their risks, ETFs continue to attract substantial asset inflows from other areas of the financial market because they are a relatively easy-to-use instrument for gaining exposure to a variety of different markets. According to Morningstar fund flows, at the end of September 2011, there were $970 billion of assets under management in U.S. ETFs, compared to just $904 billion the year before. Some argue that ETFs have enabled investors to access a wide range of asset classes that were previously limited to sophisticated investors. It has helped drive down costs in the passive investment industry, however, while cost went down, risks went up.

Some instruments or structures should only be available to the professionals who are qualified and experienced in running the required proper due diligence. Even if more information is disclosed in the future, the risks will never be sufficiently understood by the general retail market. It is very possible that in the near future ETFs will create the same banking meltdown as CDOs did in 2007, unless more targeted regulation is applied. Many of the potential risks that have been highlighted here are not specific to ETF's -- they concern other managed fund structures as well. In the case of the ETF's, the problem is amplified because they are accessible to uninformed and non-professional investors. How can we expect them to perform appropriate due diligence? More regulation is needed and for once and for all banks should take liability for their employees' attitude. In the food production industry, a firm cannot escape and hide behind an employee who happened to fail to check, for example, the perished milk that was being used in the production of a chocolate bar and then simply apologize for any resulting health problems on the basis that one of their employees made a mistake. Strict rules are applied inside the firm and outside of it to ensure that this type of mistake does not happen. Risk control systems that keep on failing in the banking system make me wonder if the banks are really failing or if top management simply ignores discrepancies in the greedy pursuit of higher returns.

Source: Exchange Traded Funds: Another Black Box?