2011: The Year Exchange-Traded Funds Were Thrust into the Spotlight

For people working in financial markets, the year 2011 could qualify as “the year of formidable public deficits on both side of the Atlantic”. Or “the year of the Eurozone crisis”. Or, on a related note, the “year of Greece” — even though Greek citizens may not like that distinction. It could also be called “the year when exchange-traded funds (ETFs) came under the spotlight”.

In April 2011, both the Financial Stability Board (FSB) and the Bank for International Settlements (BIS) published papers on ETFs (view the FSB report and the BIS report), highlighting the risks and the potential implications for stability for the financial system. In mid-September, a rogue ETF trader was arrested over a USD 2 billion loss on the UBS London derivatives desk. And lastly, the newly established European Securities and Markets Authorities (ESMA), which is advising the European Commission on securities and markets issues, recently closed a discussion paper on establishing guidelines for UCITS ETFs and structured UCITS.

Since then, the debate has been raging about the potential risks that complex ETFs structures carry, and whether or not these could have a negative impact on the stability of the financial system as a whole.

The ETF market has been growing by 40 percent annually over the last 10 years. Indeed, at the end of Q3 2010, EU ETFs totaled USD 275 billion and, while physical ETFs (plain-vanilla products that replicate an index by buying the physical securities underlying it) are dominant in the U.S., the more complex synthetic ETFs represent 45 percent of EU ETFs. CFA Institute believes that complex UCITS ETFs, and structured UCITS need particular attention to protect retail investors from mis-selling.

Nevertheless, as we underline in our response to ESMA’s discussion paper on UCITS ETFs and structured UCITS, because 80 percent of the money invested in European ETFs comes from institutional investors, it is the protection of institutional as much as retail investors in complex UCITS ETFs and structured UCITS that can help mitigate the systemic risk posed by these complex products. We also believe that the sale of synthetic ETFs and structured UCITS to retail investors should not be limited, because of their significant advantages, such as broader investment horizons, lower costs, greater liquidity, and lower tracking error in the case of index-tracking ETFs. However, investor protection should come in the form of significantly improved disclosures about the characteristics and risks of complex synthetic ETFs and structured UCITS, notably in terms of counterparty risk and collateral risk.

There is a need to monitor the development of highly complex ETFs and other structured products that could pose some risks to retail and professional investors and to the financial system as a whole. In our view, the most essential element is enhanced disclosures on the characteristics of these instruments, the risks they pose, and the potential conflicts of interests.