David Prosser: A new danger from an unexpected quarter

Outlook The investment management industry, by and large, was a bit-part player in the financial crisis, but that does not mean it is a risk-free enterprise. Indeed, risk is often to be found in unlikely places – such as exchange-traded funds (ETFs), it now turns out.

ETFs were invented by fund managers to address their own failings. Since active funds so often fail to beat the average performance of the markets in which they invest, customers frequently complain about the high charges they pay for the privilege. An ETF, by contrast, simply replicates the performance of a given index and with no expensive manager to pay, the funds are cheap, too.

So far, so good. But, as the Financial Stability Board (FSB) warned yesterday, fund management firms just can't help themselves – and while the humble ETF is a relatively straightforward product, the variations on the theme subsequently invented may be less so.

The first problem is that while ETFs used to deliver the performance of the index by buying all its constituents, some fund managers now prefer to buy derivative contracts from an investment bank that promises to pay the required returns. So what happens should the bank in question not be able to make good on its promise?

Moreover, the derivatives-based ETFs tend to hold collateral as part of the deal, which can be sold to meet redemptions from the fund if necessary. But the FSB warns a growing number of ETF providers are taking a risk by choosing illiquid collateral that might be difficult to sell in a hurry.

Even some of the simple ETFs are taking some risks. Many of them earn an income by lending out the stocks they hold to other parties. Again, what happens if the loans are not repaid?

It looks as if new rules may be necessary to address some of the vulnerabilities in the ETF sector. There has already been a crackdown in the US, where the Securities and Exchange Commission became concerned about these issues 18 months or so ago, but in Europe, ETFs come under the collective investment regulations, which are less stringent.

That potential loophole needs to be addressed. The largest investors in ETFs in Europe are institutions, who one would hope have had the wherewithal to conduct some due diligence, but there is a rapidly growing retail market too. It needs protecting.