You Can Lead An Investor To Water …

Jim, I have to agree with Matt on this one.

Your suggestion that we call funds that physically replicate an index by holding the underlying securities “ETFs”, and those that use swaps or other derivatives “ETPs” or “structured products” would be a nice distinction if it worked. Unfortunately, it doesn’t.

Looking from a European perspective, both physically replicating tracker funds and swap-based trackers can be called ETFs under the UCITS regulations, and in my view rightly so. UCITS-compliant funds have to meet minimum levels of transparency and diversification, and the standard has now been broadly accepted across Europe, and in other parts of the world.

I know that, since the onset of the financial crisis, a lot of investors have expressed a preference for ETFs that use physical replication, fearing the potential counterparty risk involved in swap-based funds, even if this is limited to 10% under UCITS.

But if you look more deeply into how physically replicating funds operate, they have risks attached as well. Most such ETFs use securities lending to add returns, with the revenues typically split between issuer and investor. But – in common with the types of financial market misnomers you mentioned a couple of days ago, Jim, in relation to hedge funds – securities lending is not lending at all. It’s a transfer of ownership, albeit with a promise to repurchase.

And while securities lending is collateralised, there’s typically no information available at all to investors about who has borrowed the stock, and what has been supplied as collateral. You could argue that there is more information available to investors in swap-based ETFs about what they hold as collateral – at least they are required to report this on a semi-annual basis, and some issuers say that they can give this information on demand.

My point here is that the more you look into the structural risks of ETFs, the more complicated it becomes, and there is no easy way of subdividing the market into ETFs and “non-ETFs”. Having said that, to me exchange-traded funds still compare favourably in terms of transparency and liquidity when you look at some of the alternatives – see, for example, what Dan Waters, former retail policy director at the FSA, the UK regulator, had to say a few months ago about the lack of risk disclosure by structured products providers. In brief, many issuers were refusing to reveal whose counterparty risk investors in their structured products were incurring, and using regulations as a convenient excuse.

A bigger potential hurdle for investors is trying to understand the risks that may result from the way the underlying index is compiled, particularly in the case of leveraged indices and in the case where there may be a return “drag” when the index is based on an underlying derivative, as is the case with a lot of commodities and some other asset classes (for example, credit).

Matt’s idea that a minimum level of investor education should be required sounds good, but what if they teach you the wrong things? Having sat investment industry exams myself, I can tell you that the UK IMC exam (to give an example), while it contains some good basic information about how to value shares and bonds, also consists of enormous amounts of mind-numbing and pretty useless information about the regulatory system, plus it teaches a method of measuring financial market risk (assuming a normal distribution, and calculating risk as the variance of returns), which evidence shows to be completely wrong.

While protecting investors from their own folly sounds like a good and worthy idea, Confucius said “a fool despises good counsel, but a wise man takes it to heart”. You can lead an investor to water, but you can’t make him drink, in other words. And, if we’re really going to try to stop people from making their own mistakes, why not ban public lotteries as well (since they offer such a terrible payout ratio and are a tax in disguise)? Why not ban those draws in airports that offer an expensive-looking car as the prize, but where your chances of winning are infinitesimal?

Ultimately all we can do is write about risks where we see them, try to cover our subjects as fully and responsibly as possible, and the rest is up to investors. If they overtrade their way into losses, or pick an index product that destroys wealth over a long holding period, that’s their problem. You can’t remake human nature.

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