They victoriously made their name as the passive low-cost magic bullet that solved all investor problems. But in the last couple of months the case for the exchange traded fund success story has blown wide open.
Between 2006 and 2010 the ETF landscape grew by approximately six times. It is not surprising therefore, that the remarkable acceleration in the sector's growth has sparked concern. The Serious Fraud Office launched a review two weeks ago to investigate the potential of mis-selling and any threats to financial stability.
In its recent Retail Conduct Risk Outlook 2011, the FSA stated that rapid growth in the ETF market had resulted in high levels of product innovation: "This creates the risk that consumers do not understand the difference between product types in terms of investment strategy, tax status and risk." - namely the increasing number of synthetic, also known as swap-based, ETF products that expose investors to collateral and counterparty risk.
Between 2006 and 2010 the ETF landscape grew by approximately six timesThe Bank of England also raised concern and on 12 April the Financial Stability Board published a note on financial stability issues surrounding ETFs.
On BBC Radio Sir Mervyn King, governor of the Bank of England, was questioned on ETFs. He was asked that given the risk associated with the complexity and opacity of synthetic ETFs, whether the regulators should be considering some sort of restriction?
He answered: "It is important to recognise the initial objective of ETFs was a very good one; it was to enable investors to invest in a wide range of shares and index in such a way that they would reduce the transactions cost that would be associated if they tried to diversify their portfolios themselves."
Sir King explained that engaging in collateral swaps was the issue. It meant investors were not just exposed to the risk of the index, which they fully understand, but also to the counterparty of the institution running the fund.
All ETFs follow the same legal construct of mutual funds and the vast majority track the performance of an index, so how are the variants so vastly different?
Within the fund there are different techniques used to replicate the index. It generally comes in two forms; physical and synthetic.
The physical will replicate the underlying indices and thus the investor becomes the beneficiary owner of the constitutions that make up that index. It rings true of the cost effective and simple product ETFs have been billed as. The synthetic variant is where it gets more complicated.
With synthetic replication the underlying securities of the index are not bought. A swap is used with a third party, usually an investment bank, to generate the index return. This then builds another dimension into investor risk with counterparty issues and questions around the basket of collateral held in the fund.
Evercore Pan-Asset Capital Management has recently excluded swap-based ETFs from its model portfolios and Oeic funds in the retail space. The move was to address investor concern after industry warnings.
Christopher Aldous, chief executive of Evercore Pan-Asset, said: "We will continue to use swap-based for the institutional market, but for the retail space there is increasing concern as to whether they are appropriate."
He added that ETFs should not be singled out as problematic because of some product complexity.
"Our view of ETFs does not change," Mr Aldous said.
"Complexity brings cost and risk. There is a pretty good offering across the board of what you would call simple ETFs. As an investor there is the choice; either slog it out in the market place with the more straight forward products or look to more complex structures that could have more potential.
"As with all investment products, complexities will happen, and all products need to be properly researched with professional advice."
John Redwood, chairman of Evercore Pan-Asset's investment committee, pointed out that in 2008 when authorities presided over market instability and a banking crisis, ETFs did not destabilise markets.
Going back to October last year, Chris Gilchrist, director of Somerset-based Churchill Investments Plc, made a presentation at the PFS Conference about the dangers of ETFs. He explained the added confusion of exchange traded notes and exchange traded commodities.
He said: "There is significant counterparty risk in ETNs which is not necessarily disclosed with clarity. Regulatory intervention is something that will certainly happen, and the ETF sector is one that needs it."
While they appear to fall under the same 'ETF' umbrella, ETNs and ETCs are not Ucits regulated. Some have pointed out that exchange traded products, also knwon as ETPs, consist of an alphabet jumble of acronyms that needs to be clarified.
Among the current furore Mr Gilchrist said there were many traditional iShares "crystal clear" physical ETFs that did what they said on the tin. And some ETNs and ETCs fall into similar characteristics; with gold and precious metals for example, the custodians are actually holding gold in a vault and are therefore physically backed.
All the problems in the sector, he said, come from entering the world of derivatives.
ETFs fall under Ucits regulation. The funds therefore can not have more than 10 per cent counterparty exposure, must have an independent custodian and a full valuation process of the assets held to guarantee at least 90 per cent of the return value.
What the rules do not specify is the type of assets chosen by the investment bank.
While the custodian must agree to the assets held, the bank could for its own reasons, decide to hold certain types of securities, and in doing so, perhaps offset some of its own risk allowances for example.
Alternatively, in a worse case scenario it could be buying stock for a corporate client and hold it on their behalf. Thus there is a darkness surrounding the quality of security that investors have.
Mr Gilchrist said: "The custodians have tightened up their act recently and the regulators will probably go further and make more specific rules to cover synthetic ETFs.
"In the first instance the regulator will probably lean on the fund managers to enforce greater transparency. Changes in Ucits regulation will probably not happen. Whether it will be easy for the regulator to go further in relation to what the investment banks do is more tricky."
David Bower, marketing director of iShares EMEA, said it was critical investors knew what they were buying.
In a total of 104 funds listed on the London Stock Exchange, iShares offers only two swap-based funds. It discloses full swap costs and ensures 'swap' is included in the fund name.
He said: "The industry needs to make sure that investors are clear on physical and synthetic ETF structures. They also need to be made aware that with ETNs, the protections available through Ucits regulation is not applicable."
The global financial crisis and Lehman Brothers collapse was an alarming wake up call in 2008. Improving product transparency and exercising more caution has been prominent in rebuilding the industry's reputation, particularly when complex dealings with third parties come into play.
The rapidly evolving variants of the traditionally low-cost, low-risk, simple ETF has quite rightly come under the same scrutiny.
Hector Sants, chief executive of the FSA, said: "The right transmission mechanism here to address these risks is through the European structure, through ESMA which is the new European regulator responsible for the securities market.
"We will indeed be actively pushing, through the ESMA process, suggestions that the rules should be tightened, particularly in relation to the synthetic ETFs."
The concerns have been spreading like wild fire across the industry and while regulator attention has been firmly captured, what happens next remains to be seen. At the moment, it seems the more the label is pulled back on ETFs, the further away you get from that simple magic bullet they have always been marketed as.
