Smith, who previously criticised exchange-traded funds back in January, raises issues around daily compounding, collateralisation and countrparty risk in his latest blog posting.
Such topics have been the focal point of numerous regulatory warnings of late. Fund houses such as Evercore have chimed in too. But Smith also highlights another danger he says is inherent in the structure of a product that combines features of an open-ended fund with those of a closed-ended product.
The fact that ETFs are tradable on the secondary market, Smith says, means there is a possibility that market participants will short ETFs themselves. The ability of ETFs to create new shares means there is no restriction on the amount of the ETF that can be shorted.
This causes a problem whereby “the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest. This is a significant problem given reports that there has been short-selling up to levels of 1000% short in some ETFs”.
Thus, retail investors, at whom Smith says ETFs are increasingly being marketed and targeted, may find that money they believe to have been invested in exchange-traded funds have “in effect been lent to hedge funds”.
“The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do.”
Creating the shares represented by the cumulative buying interest, he says, is easier said than done given the size of many ETFs relative to their indices.
“[A recent fund raising proposition] describes the pace of development in the ETF area as ‘breakneck’. I just wonder whose neck will eventually get broken,” Smith concludes.
Counterpoint
The European Fund and Asset Management Association, meanwhile, has responded to concerns raised by the Financial Stability Board last month over exchange traded funds.
“We note the concerns raised by the FSB regarding potential conflicts of interest, synthetic exposure, securities lending and the use of collateral. We wish to stress that, whilst these types of issues and risks are common across the financial services industry, they are managed and mitigated to a large degree within the highly regulated framework of Ucits,” EFAMA said in a statement.
The organisation said it does “not understand” reference made by the FSB to “the liquidity of large asset managers”, noting that assets of a Ucits ETF are held segregated from the balance sheets of the Ucits manager, portfolio manager or counterparty. EFAMA added that the liquidity of ETFs themselves was also ensured by Ucits risk management measures.
“Efama welcomes a constructive dialogue with regulators with respect to ETFs and agrees with the need for transparency to investors regarding investment strategies, synthetic or physical replication, and collateral/fund assets composition,” said Peter de Proft, director general of EFAMA.
“Besides the extensive requirements of the Ucits Directive, Ucits ETF providers already provide for a higher level of transparency on fund assets and swap exposure via their websites on a voluntary basis.”
