Have exchange-traded funds outgrown their specialist market?

In any industry where the seller has a lot more information about their product than the buyer, there is always the risk of mis-selling – because the salesperson knows too much and the customer too little.

This is why mis-selling tends to be prevalent in the pharmaceutical and finance industries.

In 2011, research was carried out into ETFs alongside the New Economics Foundation, asking two questions – should investors ever place money in commodities? And if so, by what mechanism could they do so? The outcome was clear. Never put money in any agricultural commodities, and only in commodities where there was a very clear environmental driver. For example, platinum when the price was being driven by demand for catalytic converters.

In looking at how to do so, a complex world of ETFs, ETCs, synthetic ETFs, inverse-geared ETFs and even actively-managed ETFs reared its head. Each of these specialist and complex instruments were developed to meet a specific specialist requirement – usually short term, trade-able exposure to an underlying index or commodity. However, the growth in ETFs to nearly 3,000 funds today managing assets of $1.5trn (£953.5bn) from less than $100bn in 2000, suggests they may have outgrown their specialist market and may now be being sold inappropriately.

Consider these examples. If an investor bought a three-times leveraged ETF and the underlying index moved by 8 per cent, would the investor expect a loss of 25 per cent? Equally in a three-times-inverse-leveraged ETF would an investor expect a 90 per cent loss for an 8 per cent increase in the index? No, and yet all these are examples of returns.

Equally an ETF might make sense when it is small part of the market in a particular commodity, but if it dominates then the price of that commodity becomes influenced by the ETF flows themselves.

The scale of the ETF market is such that everyone should be concerned. In many cases ETFs are side-bets on an underlying index or commodity. This is analogous to the asset backed securities, collateralised debt obligations and collateralised mortgage obligation side-bets on the sub-prime mortgage market. Look where that ended up. As ever the message is ‘buyer beware’, but there is also the need for advisers to be ‘industry beware’.

Peter Michaelis is head of SRI at Alliance Trust Investments