Asset managers and IFAs have countered active fund manager Terry Smith's warning ETFs are a "new investment fad" that investors misunderstand.
In an open newsletter to shareholders in the Fundsmith Equity Fund, Smith criticised the more complex strategies now offered under the ETF umbrella, focusing in on synthetic and leveraged funds.
Attacking "so-called synthetic ETFs" and "so-called swap agreements," Smith asks what if the counterparty supplying the swap defaults?
In addition to Ucits regulations that restrict counterparty exposure to 10% of an ETF's net asset value, most ETF providers now work with fully or over-collateralised models.
However, Smith argues that "collateral is an imperfect science even where it is held".
Evercore Pan Asset chief executive Christopher Aldous disagrees. He says: "We look at this very carefully. Most synthetic ETFs now very, very well collateralised, rebalanced on a regular if not daily basis and topped up to at least 100% of the fund's NAV.
"With a swap, your risk is that the counterparty doesn't deliver, but if you think about it a swap is most likely to fail when the market is collapsing. Collateral in these funds is often less volatile than the index being tracked. If that's the case, it's likely to fare better than the shares the fund nominally holds; it's more likely that you're going to end up owing the swap-provider."
On a more fundamental basis, Smith questions the viability of accessing markets where liquidity is poor, claiming that the potential for the ETF's performance to diverge from that of the underlying assets is "obvious".
Aldous says: "Funds that don't track liquid assets are dangerous by definition. Exchange traded instruments lose their viability if not liquid." However, this is not necessarily an issue related to synthetic replication. Aldous adds: "Our personal view is that if synthetics are properly constructed and managed they are at least as safe as traditionally replicated funds. We believe in them and we've been doing well in them."
Echoing the US Securities and Exchange Commission's warning on leveraged and inverse ETFs, Smith goes on to say "it would not be surprising if in many cases they were being used inappropriately as if they are index funds", branding the cumulative returns on leveraged ETFs as "apparently perverse".
ETF Securities, which provides a range of leveraged products, says it "would always encourage investors in short and leveraged ETFs to actively manage their positions and understand what they are investing in."
Similarly, Aldous says: "We warn all investors about the dangers of leveraged and inverse products. I can't really imagine why investors would use ETFs for these purposes - there are other instruments available."
However, ETF Securities stresses that unlike derivatives or spread betting products, ETF investors can only ever lose their initial investment. In fact, the company argues, the transparency of ETFs provides a clear indication of market positioning and the amount of leverage in the system.
Smith attributes the success of ETFs to "the failure of active management", coupled with a decade in which equities have performed badly, but counters that ETFs themselves are not as inactive as investors think. Describing the funds as "a little understood type of investment", Smith says: "I suspect that many ETF investors are breaking the golden rule about investing in an asset they do not fully understand."
In contrast, Anthony Badaloo, an IFA at Church Hill Finance, says: "We must not forget that traditional investment funds are also largely misunderstood by investors who hold them.
"While I accept and agree that there are some exotic and synthetic ETFs being launched, traditional funds have also been known to use derivatives as part of their strategy - the difference being that the consumer was not always aware of it. At least with ETFs we have some transparency."
He adds: "My philosophy on ETFs is I think they are going to become an essential part of most portfolios and in the future their success is going to call into question the value of fund managers."
Ultimately though, the charge that investors need to understand what they are buying is undeniable. Aldous says: "Smith makes some very good points and some less good ones. iShares' slogan ‘Not all ETFs are created equal' is very true. The moral of the story is that investors need to look carefully at what they're buying and do their due diligence."
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