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Fundsmith founder warns of ETF misselling

Fundsmith founder Terry Smith has joined the mounting criticism of exchange-traded funds, saying certain types of ETF could spark a misselling scandal.

Smith says investors “could be heading for another tragedy” with so-called ’synthetic ETFs’.

He says the average investor simply regards them as another form of index tracker. However many ETFs are now created synthetically and are really based on swap agreements with investment bank counterparties.

He says: “What if the counterparty supplying the swaps defaults? This risk may once have been considered theoretical, but after the collapse of Lehman… it surely no longer is.”

Smith also questions the growing trend for synthetic ETFs to target markets like Chinese A-share market that are not normally available to retail investors.

He says: “The opportunity for the performance of the ETF to diverge from the performance of the underlying assets and therefore from the investors’ expectations in these cases seems obvious.”

Smith also slams leveraged and inverse ETFs, which aim to amplify or reverse index performance, saying they can produce “apparently perverse” results that worsen market volatility.

He adds: “If it transpires that many investors are heading for another tragedy in a little understood type of investment described by a three letter acronym – ETF – this will not be a first.

“After all, remember the CDOs, CLOs from the alphabet soup of toxic assets in the Credit Crisis? Stand by for another misselling scandal?”

Former Tullet Prebon chief executive Smith announced plans to launch asset manager Fundsmith in September 2010.

In December Money Marketing revealed a leveraged gas ETF from ETF Securities had lost 90 per cent in a period where the gas price remained static.

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Comments

There are 3 comments at the moment, we would love to hear your opinion too.

  1. Tyburn Asset Management 10th January 2011 at 2:38 pm

    Totally agree with everything said only a matter of time before investors get burnt. Liquidity is exposed at times of great supply and demand. Lets wait for the inevitable sharp pull back from parabolic rise in the Gold price and see how many of the Gold ETF’s actually have the physical backing to cope with the redemptions.

    Leveraged ETF’s should not be available to retail investors.

  2. There is no doubt that there is a level of due diligence required for synthetic ETFs. And there are sound structures that will mitigate the counter party risks – many already do.

    But it is also true about almost any retail fund – what about the stock lending risks in many apparently simple mutual funds??

    There is a wider question about the fact that many of these structures are UCITs qualifying and as Tyburn highlights some (e.g. leverage) should only be available to professional investors.

  3. All fair points. Anything with leverage / liquidity should have wealth warnings….but Mr Smith was CEO of a firm which provided brokerage on products which have loads of counterparty risks !

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