Keep track of what’s in your ETF

I came across a new organisation last week – the Financial Stability Board. Maybe I should have been aware of its existence but as it was only
set up two years ago, perhaps I could be forgiven for not having heard of it before.

The reason it crossed my radar screen was a report it published into exchange traded funds and how they might contain the seeds of the next market meltdown.

ETFs are the great success story of the new millennium.

They already account for 2 per cent of global equity market capitalisation, according to the FSB report, and – more important – 5 per cent of
global mutual fund assets.

But here’s the rub. Over the past 10 years, they have been growing in value by 40 per cent a year – nearly 10 times the rate that mutual funds
have been growing.

But the FSB’s concern is not over the success of the industry. Rather it is because of the direction that new product launches have been taking. The original concept allowed investors to track an equity index through a lowcost vehicle that held the underlying shares, with trading taking place continuously throughout the day, but many of the more recent launches have provided access to less liquid markets,
using synthetic techniques.

It happens that two of the three biggest ETFs worldwide track emerging market indices but it is the expansion into commodities, bonds and
other more esoteric asset classes that is beginning to ring alarm bells. That, and the fact that by, using derivatives – the synthetic approach, all
manner of bells and whistles can be added on. Today there are leveraged ETFs and socalled “inverse” ones, which provide the opposite effect to
the performance of the asset. Add to this the incestuous nature of some of the developments in this arena (investment banks are devising new instruments which can be sold as part of a wider programme of business creation) and you start to understand why the worries exist.

Not all exchange traded products are even funds any more. ET notes and ET vehicles are debt products. It all feels rather reminiscent of the
explosion of products that preceded the credit crunch.

It happens that Terry Smith, always a somewhat contro – versial figure in the investment world, raised concerns over ETFs back in January.

In a blog on behalf of his new Fundsmith venture, he wrote: “Do you know what’s in your ETF?” Like the FSB, he was worried about the growth of more complex products, accessing less liquid markets with insufficient transparency.

ETFs are a valuable investment tool. I know one experienced investor who always recommends them to those seeking to build a diversified portfolio, rather than actively managed funds. But he only uses plain vanilla ETFs.

Perhaps, with the continued expansion of this section of the market, it would do no harm to look under the bonnet a little more carefully in future before recommending them.

As for the Financial Stability Board, it was formed in April 2009 as the successor to the Financial Stability Forum, which was itself only 10 years old. It was the G7 finance ministers that created the forum as a means of bringing together information and financial intelligence from
within the seven richest nations in the world.

In the wake of the banking crisis, members of the G20 felt they should be involved as well – and the FSB was born. I shall look out for papers
from it more assiduously in future.

Brian Tora is an associate with investment managers, JM Finn & Co