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It takes two to contango

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Gregor Watt reports the ETF market covers some esoteric areas and advisers are wary of products that are difficult to understand

The rapid evolution of ETFs from passive, lowcost index trackers to more exotic forms involving leverage, shorting and a variety of different structures, from synthetic to full ownership of the asset or index they are tracking, has raised questions about how easy it is for investors and IFAs to understand the inner workings of the products.

This year, the ETF market has seen a number of firsts launch into the market.

In September, iShares launched its first UK swap-based products offering exposure to Russia and India while October saw the company launch the first currencyhedged ETFs in Europe.

In addition, investors already have access to ETFs in specialist markets including heating oil or lean hogs.

Hargreaves Lansdown investment manager Ben Yearsley says: “One thing you would say about ETFs is there is a lot of weird and wonderful stuff there. If someone tried to launch them as a unit trust, the regulator would never let you.”

This proliferation of different ETFs can make it extremely difficult for investors and IFAs to figure out just what is going on under the lid of any given product.

Yearsley says as ETFs are freely available through any stockbroker and a growing number of platforms, investors now have access to a range of investment they would not have had direct access to previously but this is exposing investors to risks they are not aware of.

ETFs have been widely praised for allowing investor to get exposure to commodities, such as oil, gas and gold, which have traditionally been uncorrelated to equities and bonds. But these markets come with their own risks. One good example is contango, which is a condition in commodity markets where longer-term futures contracts are more expensive than the spot price of a commodity. This can result in the value of an ETF going down even though the price of the commodity is increasing as the fund is buying more expensive futures.

He says: “Do people really understand how they work? I don’t think they do. Do people understand contango and those sorts of things? Do people really realise what is underlying them?”

The proliferation of choices and the exotic nature of many of them has led some IFAs to adopt a policy of disregarding anything out of the ordinary.
AWD Chase de Vere head of communications Patrick Connolly says: “There are two factors. One, it is very difficult to understand how some of these work and as a result, what the underlying risks are.

“Two, ETFs can, in some circumstances, follow some fairly obscure types of investments and investments that we would not normally put in client portfolios, so there is an investment risk attached to this as well. Those two things combined make us more than wary, in fact, we do not use certain types of ETF simply because of that.”

Yearsley says the combination of either exotic investments or complicated structures should mean anything other than bog-standard ETFs should be ruled out for retail investors.

He says: “Most of the ETFs out there are not sensible ideas for retail clients. The plain vanilla ones and even things like gold, I have got no problem with but some of the more esoteric ones, you really have to wonder. Retail investors should not be going near them.”

What should ETF providers be doing to boost their popularity and take-up by advisers?

Yearsley says: “Stick to normal products rather than trying to be too clever.”

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