Exchange-traded funds (ETFs) started as a "plain vanilla" product: a type of low-fee, tax-efficient mutual funds holding index-mimicking portfolios. The first ETF was formed by the Toronto Stock Exchange in the 1980s and has garnered spectacular popularity in recent years. According to a recent article in The Economist, the number of ETFs in America has almost tripled from its 2006 level of 343 to 1,098 in December 2011. This volume increase has been accompanied by substantial financial innovation beyond that found in a traditional index-mimicking ETF (leveraged ETFs, inverse ETFs and synthetic ETFs are all great examples of this innovation).
Last week we had a blog post introducing the basic properties of synthetic ETFs. A synthetic ETF attempts to generate returns of an index using derivatives instead of physically holding the underlying index portfolio. An unfunded synthetic ETF is based on a total return swap, while a funded synthetic ETF is essentially issuing equity-linked notes (ELNs) promising specified returns. Usually the counterparty of the total return swap or the provider of equity-linked notes is an affiliate of the ETF manager. Furthermore, banks typically have full discretion over the composition of the collateral portfolio. As a 2011 BIS working paper points out, this arrangement provides incentives (for example, reducing the bank's regulatory capital requirements) for banks to post low credit quality and illiquid securities as collateral assets when they act as swap or ELN providers. This practice could lead to substantial losses for ETF investors when banks fail to deliver the promised returns.
That being said, physical ETFs are not completely without risk. Although in a less obvious way, physical ETFs also exhibit counterparty risk. Many physical ETFs routinely lend out securities to other investors to increase their returns, exposing ETF investors to the possibility of counterparty's default. Also, as the territory of the indexes used by ETFs expands, the basket securities would unavoidably leave the liquid stock market and enter into more thinly traded asset markets, resulting in an increase in liquidity risk of the ETFs in the future.
The momentum of ETFs' growth seems to be unstoppable at this moment. However, as ETFs evolve and the complexity of their operations increases, more transparency and proper disclosure should be required.
