Fund managers argue that one type of ETF is too risky for investors, but our columnist disagrees.
There is no shortage of criticism about index funds from active fund managers. In the early days of Vanguard, its first index fund was derided as un-American. Others have argued that passive investing helps to fuel bubbles, while some claim that it poses a threat to the very functioning of capitalism.
ETFs have also been subject to criticism. A favourite of many critics has been that so-called synthetic ETFs are riskier than many investors realise.
Synthetic ETFs, in contrast to a physical ETF, do not own any of the shares in the index they are following. Instead of buying the shares, the index is replicated through so-called swap transactions. This means that the ETF provider enters into an agreement with a financial institution that is then obliged to deliver the index return.
There are several advantages to this. Sometimes, the index an ETF intends to track is not liquid or easily investable, making synthetic replication preferable. It is also often the case that synthetic ETFs have a lower tracking error and, sometimes, lower fees.
One of the most vocal critics of synthetic ETFs has been star fund manager Terry Smith. As he writes in his recently published book Investing for Growth: “Anyone who has studied the events of the Credit Crisis should be able to spot the potential problem [with synthetic ETFS]: what if the counterparty supplying the swaps defaults?”
He continues: “The risk may once have been considered theoretical, but after the collapse of Lehman and the need to rescue AIG in order to prevent the contagion from a default, it surely no longer is. True, the ETF should be holding collateral against such a failure, but collateral is an imperfect science even where it is held – which it is not in all cases.”
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Elsewhere Smith also argues: “If a fund which is described by the words ‘synthetic’, ‘derivative’, ‘swap’ and ‘counterparty’ does not cause you obvious concerns, I suggest you may need to study the events of the Credit Crisis of the past four years more carefully.”
Of course, his argument is not anti-passive investing. Smith is not, unlike some managers, launching a cynical attack on passive investing owing to its threat to those who actively invest.
Smith has noted several times during his career that index funds are perfectly reasonable investment vehicles and that passively tracking an index can be a preferable way to invest. In his book, he also says: “I have long and publicly maintained the best equity investment for most investors most of the time is an index fund because of its low costs and outperformance of most active fund managers.”
It is also worth noting that much of the criticism of synthetic ETFs by Smith is in articles published in 2010 and 2011 (the book is a collection of articles over the past decade). This was only a couple of years after Lehman Brothers went bust.
With memories of an almost financial Armageddon so recent, fears about counterparty risk make much more sense. But this is precisely the point: is it still reasonable to worry about counterparty risk 12 years after the crisis?
The 2008 financial crisis did show how real counterparty risk can be, but such financial meltdowns are rare. At the same time, banking regulation and supervision has improved significantly, and the risk of a widespread banking crisis seems remote (although, admittedly, many would have said the same thing in 2006).
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There is also the added fact that it is now common for most ETFs to use several counterparties. This means that if one of the banks they are using as a counterparty goes the way of Lehman, it has less of an impact. In other words, the risk is spread out.
Of course, there is still the risk that all the banks in question could fail together. But if you think we are in for a repeat of the systemic meltdown of the financial system, perhaps you are best steering clear of investing in equities entirely and buying gold or other real assets.
Rather than worry about a theoretical and low probability repeat of 2008, it is perhaps better for investors to be more concerned about the drag on performance from ETFs with high fees and high tracking errors.
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