Exchange Traded Funds (ETF)

This universe has seen massive growth since the appearance of the first ETF in 1993 in the form of the SPDR S&P 500. Today, around 2600 ETFs are traded on a variety of stock exchanges, and volumes exceed 1000 billion dollars.

In recent years there have been considerable advances in how ETFs are constructed, especially since the introduction of what is known as the synthetic replication method (which uses derivative instruments), as opposed to physical replication (purchase of all or some of the underlying components). These advances have generated the appearance of new risks, similar to those associated with certain structured products. We therefore consider it important to review the main risks presented by these instruments.

The first concerns their ability to replicate the performance of the asset they are intended to represent. Observation shows that, over the long term, the performance of different ETFs intended to represent the same asset can vary substantially depending on how they are constructed. This risk has grown recently with the introduction of new ETFs aimed at replicating asset classes that are exotic, have low liquidity, or offer short or leveraged exposure.

Here, for example, we could mention ETFs that seek to deliver the inverse of the performance of the underlying, with or without leverage. The fact that the replication is based on daily performance and the use of derivative products may well lead to significant performance differences compared with the underlying. This is particularly true in the case of leveraged ETFs – which offer a multiple of the daily performance of an asset – simply because of the cumulative effect of repeatedly multiplying the daily performance over a given period.

There are also commodity ETFs which, with the exception of precious metals, are mostly based on futures contracts. However, the loss of performance associated with the regular renewal of these contracts each time they expire may be very high, especially in a contango situation (an upward sloping curve for forward contracts reflecting their duration). It is thus almost impossible to replicate the performance, as measured by spot prices, of many commodities.

The second main risk factor concerns counterparties. The use of swap instruments (contracts to exchange a stream of cash flows with a financial institution) has ballooned in recent years, especially in Europe, where ETFs based on this replication method now account for three-quarters of the market. However, these contracts generate a counterparty risk with regard to the institution issuing them. Of course, reasonably effective protection measures have been put in place by ETF issuers, particularly since European legislation (UCITS) requires collateral worth 90% of the value of the ETF to be pledged. This implies that if the counterparty should default, the risk of loss to the investor will not in theory exceed 10% of the value of the ETF. Establishing the equivalence between the collateral pledged and the underlying which the ETF aims to replicate can nevertheless present a very real problem.

Exchange traded commodities/certificates (ETCs) and exchange traded notes (ETNs), which are often treated as ETFs even though they are based on a different legal structure, present a much greater counterparty risk in terms of the actual product. Here again, issuers offer reasonably effective protection measures, by means of collateral or insurance contracts supplied by a third party. It is always vital to look very carefully at the construction of the product.

Finally, some ETFs that have appeared recently are based on relatively illiquid strategies such as hedge funds or private equity. Attempting to replicate such strategies faithfully using an ETF involves trying to create artificial liquidity, which is not possible in our experience. In reality, these ETFs either use statistical models which have not yet proved themselves capable of adequate replication, or seek to achieve replication by means of segregated mandates in a limited universe of strategies and managers.

In conclusion, despite the apparently straightforward image of this class of product, recent developments concerning ETFs mean that rigorous analysis is crucial if the right product is to be selected. At the same time, investors who make the necessary effort will enjoy access to what is now a very diverse universe. ETFs thus offer efficient access to a multitude of sectors, themes and investment styles. They provide instant exposure to an underlying trend, and allow investors to withdraw again just as rapidly. They are particularly suited to portfolio construction using the core/satellite approach, and can also offer an alternative to certain derivative strategies.