Exchange-traded funds: a timebomb likely to blow up?

ETFs have the potential for accelerated earnings but there are risks

An ETF tries to reflect the market by acquiring the underlying securities in the index it tracks. photograph: brendan mcdermid/reuters

An ETF tries to reflect the market by acquiring the underlying securities in the index it tracks. photograph: brendan mcdermid/reuters

Thu, Jul 3, 2014, 16:26

Since their creation in the early 1990s, exchange-traded funds, or ETFs, have found favour with many an investor looking to gain exposure to a particular index or benchmark at a lower cost than a similar actively managed fund.

However, in recent months the shine of an ETF has appeared to tarnish, with industry heavy-weights such as Blackrock’s Larry Fink arguing that structural problems associated with the product have the potential to “blow up the whole industry one day”.

He’s not the first to point a finger at leveraged ETFs, but when Fink, head of the world’s largest investment fund – and ETF manager through its iShares operation – asserted that ETFs could be dangerous and could pose a systemic risk, the world listened. But what are the risks inherent in a leveraged ETF and should Irish investors be concerned?

What is an ETF?

When they were first created, ETFs primarily offered investors low-cost access to a variety of indices such as the S&P 500, FTSE 100 and Nasdaq 100.

Unlike a typical actively managed mutual fund which might be trying to beat the market, such as the aforementioned S&P 500, an ETF tries to reflect the market by acquiring the underlying securities in the index it tracks.

Traded like shares, ETFs are quoted on a stock exchange and offer the benefit to investors of broad diversification – at a lower cost. Such a structure has allowed Irish investors to swap an actively managed US fund, which was basically tracking the S&P 500 but charging 1 per cent to do so, for an ETF, which may have annual charges of as little as 0.2 per cent (excluding brokerage fees).

So an investment of €50,000 in an ETF would have returned €2,200 more over five years, based on an annual return of 5 per cent and the lower fees and charges.

And, as they are traded on the stock market like a share, a world of investment opportunity also opened up for Irish-based investors, allowing them to invest in ETFs tracking everything from emerging market corporate bonds to infrastructure funds.

“ETFs have been a very successful product. There is nothing wrong with an ETF instrument itself; it’s a structure that you can passively manage and track equity exposure for your fund,” says Ian Huggard, head of Irish equity sales at Investec Bank.

Globally, the ETF market is worth about $2.5 trillion, with BlackRock’s iShares ETFs range taking a 39 per cent share of the global ETF market, followed by State Street and Vanguard.

Leveraged ETFs Where problems might arise however, is with the leveraged equivalent to an ETF. Introduced by product providers in recent years, these work by using derivatives and debt in order to try and boost returns, and they are typically offered on a long (bull) and short (bear) basis.

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