The exchange traded fund sector has been having a rough time lately. In June the Bank of England said in its Financial Stability Report that ETFs were complex and opaque and badged synthetic ETFs as particularly risky.

More recently the Serious Fraud Office warned that ETFs could be used for money laundering due to their lack of transparency.

But are ETFs as risky as they sound?

Some of the fuss around the products has been due to their fast-growing popularity, and the regulators have suddenly sat up and taken notice of them. Specifically, the Bank of England says there may be risks that investors are not aware of or do not understand.

‘Although both types of ETF [physical replication and synthetic] effectively offer the same service to investors, synthetic ETFs appear to do so at a generally lower cost. It is possible that the additional risks associated with synthetic replication might not be fully understood by investors who are attracted by the lower costs,’ the report said.

These ‘additional risks’ include the possibility of investors losing money if a counterparty or provider defaults.

There are various safeguards in place though. ETFs are regulated by Ucits, which stipulates that an ETF is not allowed to invest more than 10 per cent of its prevailing net asset value in swaps issued by a single counterparty.

Most synthetic ETFs are also more than 100 per cent collateralised. The collateral is held separately from the provider’s assets and often reflects the index that the ETF is tracking, for example a FTSE 100 ETF might have a basket of UK equities as its collateral. So only a large move in that particular market would affect the collateral. It is normally checked daily by the provider so the collateral can be topped up if the market has fallen.

Indeed, last week a report by Bank of America Merrill Lynch claimed that concerns by regulators that synthetic ETFs could pose the threat of systemic risks were 'overblown'.

Complications

Synthetic ETFs are not as risky as some commentators believe, but they are complicated. The industry is split over whether private investors should steer clear of them.

Ben Gutteridge, fund analyst at Brewin Dolphin, says headlines such as ‘ETFs pose a genuine systemic threat’ tarnish a very useful and cost effective area of the market, which is generally managed to a very high standard.

He is indifferent as to whether an ETF is constructed using physical or synthetic replication, provided the synthetic replication method uses ‘acceptable practices’, such as collateralisation of more than 100 per cent.

Martin Bamford, managing director of Informed Choice, says he prefers physically replicated ETFs. ‘The risks associated with synthetic replication techniques are probably not as severe as the Bank of England suggests, although in the event of another major global crisis it makes sense for the ETF to hold the underlying assets, rather than rely on a counterparty and collateral to make up the difference.’

He adds: ‘We would steer clear of synthetic ETFs, ETFs tracking obscure or illiquid markets, and any inverse ETFs. The mechanics and risks associated with these ETFs are too complex for the majority of investors to understand.’

Gina Miller, partner at SCM Private, a boutique that holds ETFs in its portfolios, says she is ‘astonished’ by all the negative press. ‘In fact the average synthetic ETF we hold has over 110 per cent collateral backing. For our clients to actually lose money requires the bank to go bust and then the collateral - which we can review daily - to fall by over 10 per cent,’ she says.

However, while Miller says she will not switch out of synthetic ETFs, Evercore Pan-Asset, which also uses ETFs in its model portfolios, has announced that it will exclude synthetic ETFs due to ‘concern among our IFA partners and their clients’.

A Morningstar report released last week looks at synthetic ETFs in more detail. It says that although the research burden into whether ETFs are safe lies with the investor, providers are becoming more transparent.

'Great progress has been made to the transparency of providers' collateral and/or substitute baskets, mainly due to investor pressure on ETF providers. A handful of swap-based ETF providers are now disclosing snapshots of their substitute/collateral baskets on a daily basis on their websites and more providers have recently said that they will follow suit,' it says.