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ETF risks need to be made clearer


EXCHANGE-TRADED funds (ETFs) are blooming like mushrooms after rain. But their rapid growth and evolution have now prompted some regulators to consider if ETFs are really as safe as so claimed, particularly with the proliferation of ETFs that rely on synthetic replication.

While one should not be too quick to vilify synthetically replicated ETFs, it is increasingly clear that the marketing of such ETFs as being safe for retail investors deserves careful review, especially by regulators here.

And Singapore lags Hong Kong in flagging the risks of these ETFs to retail investors - a regulatory gap that may need to be narrowed, and soon.

UK fraud prosecutors have started to review how ETFs are being sold, said a recent Bloomberg report, amid fears by the UK's Financial Policy Committee that such funds could pose a new set of systemic risks. The Serious Fraud Office has started to review the ETF market because it sees 'similar characteristics to the collateralised debt obligations that helped spark the financial meltdown in 2008', Bloomberg noted.

Opaque and complex

UK's Financial Services Authority has gone even further to warn that some of the risks posted by synthetic ETFs are not suitable for retail investors. It is also looking to ban certain types of ETFs, which it says are veiled in 'opacity and complexity'.

Hong Kong has been proactive in its approach towards synthetically replicated ETFs, which track an index typically through derivatives. Late last year, Hong Kong's Securities and Futures Commission required all such ETFs to have a mark next to their stock names so that investors can quickly distinguish ETFs that are backed by physical securities - or funds buying stocks according to their weights on the index to replicate the index's performance - and those that rely on synthetic replication.

Hong Kong - which has the largest ETF market in Asia-Pacific by asset size - has also provided more information on synthetically replicated ETFs on the stock exchange's website, including the risks associated with such funds and how investors can spot them.

These are risks that have been debated in market circles.

Detractors claim that because synthetic or swap-based ETFs hold assets that could have absolutely nothing to do with the index they track, a poor choice of assets means greater counterparty risks.

In their defence, ETF providers point out that a fair number of ETFs here follow the UCITS iii (Undertakings for Collective Investments in Transferable Securities Directives) structures - structures imposed by European regulators - that limits counterparty exposure to 10 per cent.

The structure of such funds is also critical. An ETF that relies on a 'funded swap' structure, for example, is at a greater risk than funds that have an 'unfunded swap' structure. An ETF with a 'funded swap' structure would pass on cash to the swap counterparty, who provides the total return of the index replicated and posts collateral - but these are assets that the ETF does not own.

By contrast, an ETF using an 'unfunded swap' structure would buy securities and swap the profits from the performance of the basket of stocks against the total return of the replicated index. This means these assets belong to the fund and can be sold in the event of a default by the swap counterparty.

Cash-based ETFs, including those that hold a 'representative sampling' of the index, pose risks too as these funds are allowed to loan out or borrow securities, though some ETFs set limits on such transactions.

To be fair, ETF providers have made a lot of this information available on their websites. Investors who spend time digging around can find information about the collateral that various ETFs hold, for example.

Swap-based funds

But just because the information is available doesn't make it accessible. Critical information, such as the quality of assets held and the fund structure, for example, is often not aggregated in a single location. The presentation is often not based on a strict template - which hinders direct comparisons - and jargons are not fully explained.

All of which makes it difficult for retail investors to understand what they are really buying into.

The Singapore ETF market is heavily exposed to swap-based ETFs. The total assets under management (AUM) by swap-based ETFs stood at US$2.6 billion, more than triple that held by ETFs based on physical securities. Swap-based ETFs made up 78 per cent of total AUM, a Blackrock report in June showed.

Because Singapore's ETF market takes its cues from the European ETF market - which is a very heavy user of synthetic replication - more than 80 per cent of the ETFs found here are synthetically replicated.

Yet, while Hong Kong also has a big pool of swap-based ETFs, these make up just 35 per cent of US$28.2 billion in total AUM. In the US - the biggest ETF market globally - AUM of swap-based funds stand at 3 per cent of the total US$1.04 trillion. In Europe, that figure is at 44 per cent.

What is clear is that the ETF market is expected to grow, with global AUM expected to hit US$2 trillion by the end of next year, according to Blackrock.

ETFs do provide a good alternative for retail investors because of the low management fees. But their risks need to be made clearer to them.

What Hong Kong has done is significant: It has acknowledged the risks that swap-based ETFs pose, and has moved to make these more transparent so that retail investors are more equipped to make an informed choice. It's a path that Singapore regulators may want to follow too.