Should regulators really be worried about ETFs?

Last week, Alain Dubois, chairman of Lyxor Asset Management, in reply to a question, said that regulators have nothing to worry about when it came to exchange-traded products.

Mr Dubois is not just a fringe player in the massively growing UK and European ETF market, he is head of one of the major players and when he speaks, he weighs his words carefully.

Lyxor manages 30 per cent of the European ETF market, compared with 32 per cent by iShares, 17 per cent by Deutsche Bank and 21 per cent by a number of smaller players.

When Mr Dubois speaks, influential people listen: “There is absolutely nothing to worry about. In a way, ETFs are the most regulated product in Europe.”

So, put aside the concerns of US regulators, the close scrutiny the City regulator has embarked upon, the Serious Fraud Office’s reservations and the Bank of England’s fears, their close watch of ETFs is, to be frank, a waste of time.

Others are not so sure. In a recent report, Morningstar analysts concluded: “The rapid growth in these various investment vehicles (ETPs) has been accompanied by an increasing level of complexity in both how they are structured and the underlying exposures they seek to achieve. In the wake of the global financial crisis, it is understandable why regulators might view such a rapidly expanding and innovative niche within financial markets with caution.”

It does go on to warn that over-regulation may in fact ‘stifle’ the development of the product “that is in many regards far safer, more transparent, and less costly than many competing investment vehicles.”

This, however, is not a view shared by Terry Smith, chief executive of Fundsmith, who reminded us in January that he had warned about the toxicity of ETFs and the following concerns expressed by regulators on both sides of the Atlantic was timely.

He added: “One more problem with ETFs became apparent to me in the course of this debate. ETFs are presented as low-cost investments. Yet research published during the year [2011] demonstrated that ETFs were among the largest profit generators for some banks.

“This seems counterintuitive: how does a low cost product become a major profit contributor?” He continued: “The answer of course is that synthetic ETFs in particular provide banks innumerable ways to ‘clip the ticket’ of the ETF.

“The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides. They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions... and maybe earn leverage, prime brokerage, custodian and registrar fees.