What are the Risks of European ETFs?

Exchange-traded funds have traditionally been perceived as vehicles combining the diversified exposure of mutual funds with the low-cost, flexibility, ease and liquidity of trading enjoyed by publicly listed stocks, while also offering lower-expense ratios and better tax-efficiency relative to mutual funds.

Author(s):

Noel Amenc

Professor of Finance, EDHEC Business SchoolDirector, EDHEC-Risk Institute

Frederic Ducoulombier

Director, EDHEC Risk Institute-Asia

Felix Goltz

Head of Applied Research, EDHEC-Risk Institute

Lin Tang

Senior Research Engineer, EDHEC Risk Institute-Asia

Most ETFs are passive, index-tracking investment vehicles, which as such, have transparent economic exposure and simple payoffs. Product innovation in the ETF industry has led to the development of inverse and leveraged passive vehicles, of vehicles tracking strategies, and of outright active vehicles; these new forms of ETFs represent less than 5% of overall assets under management in the ETF industry. The growth of ETFs and the legal limitations imposed on the fund structure in most jurisdictions, notably those relating to diversification and eligible assets, have also lured products structured as debt obligations to exchanges. As notes, these exchanged-traded products (ETPs) tracking the performance of a single asset, a basket of assets or an index need not comply with fund rules and expose investors to the credit risk of their issuers. While ETFs are natural building blocks for investment by retail investors, the European ETF market is mostly institutional; retail participation is under-developed, not least because distributors have long been allowed to channel investors towards products with high commissions. However, European and country-level initiatives aimed at removing or disclosing conflicts of interest in retail distribution are expected to fuel investor interest in ETF markets. Against this backdrop and in the context of the diversification of the ETP landscape, regulators have voiced concerns about the ability of retail investors to understand differences in product types, investment strategies and risks. More generally, the rapid growth and innovations in the ETF market has led financial stability organisations and regulators to start looking into the potential risks of ETFs as a matter of precaution. The key areas highlighted for attention have been counterparty risk, liquidity risk, systemic risk and possible detrimental impacts of ETFs on their underlying markets, potential risks of innovations such as leveraged and inverse ETFs, and the possibility of confusion between ETFs and other ETPs. To the extent that such a debate can promote a better understanding of the ETF market and lead to improvements in terms of risk management practices by ETF providers and investors, it is useful. It is necessary, however, that any debate be based on facts or a sound theoretical framework, and that the bigger picture not be obscured by biases or undue fixation on the selected issues of the day. Unfortunately, we feel that the debate on the risks of ETFs has started off on the wrong foot and that the initial confusion has been amplified and compounded by competing interests jockeying for position, with adverse impacts not only for the ETF industry but also for the ultimate goals of sound regulation.

Type: Position paper
Date: le 19/01/2012
Research Cluster : Finance

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