25 May 2011

FN: Swelling ETFs draw fresh fire

The rapid growth of the Exchange-Traded Funds movement is leading to an increase in the number of attacks being made on its credibility, as investors and regulators fret over the way an ETF snafu could disrupt the capital markets.

Data for April showed record ETF sales of $25.3bn, with the industry on target to rise in value from the current $1.67 trillion to $2 trillion by early next year. The US mutual fund industry needed 66 years to put on assets worth a trillion dollars. It has taken the ETF industry 18 years to hit the same milestone.

 

Investment banks are making rapid headway with ETFs by using swaps to replicate the movement of indices. Credit Suisse and UBS are among the many banks gaining market share.

 

With the credit crisis etched so deeply in the memory of investors, and regulators, attacks on the movement have been inevitable, not just because it has grown so much, but because products often use derivatives and are pulling billions way from traditional funds.

 

Critics point out Collateralised Debt Obligations triggered the last set of problems, when it emerged the assets they owned were not worth owning. This time round, can we be sure that ETFs are backed by enough assets, or collateral?

According to the Bank of England’s Tucker, tougher surveillance is needed: “For both physical and synthetic funds, the underlying collateral pools are being swapped to provide financing for dealers and banks. It is not clear whether bank supervisors have caught up with this, or whether the risk of collateral swaps being called is treated appropriately in regulatory maturity-mismatch ladders”.

 

Smith, a long-standing critic of ETFs, argued they are in permanent danger of disruption through shorting activity by hedge funds, which leads to the risk that investors end up buying units from short sellers which have not yet been officially created. This could lead to a serious imbalance between the number of shares in issue and underlying assets. He concluded: “This is a significant problem given reports that there has been short selling up to levels of 1,000% short in some ETFs".

 

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