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ETFs Are Not Toxic – Brewin Dolphin

Joseph Milton

3 May 2011

Analysts at the investment management firm Brewin Dolphin have questioned the conclusion of a recent report by the Financial Stability Board - that ETFs are a “toxic” investment.

Ben Gutteridge, divisional director at Brewin Dolphin Fund Research, says the firm is confident appropriate safeguards are in place at major UK ETF providers.

“We would agree that there are some other less obvious issues to be considered when investing in ETFs,” says Gutteridge.

The comments come at a time when a number of commentators have argued that the increasing complexity and profusion of these exchange-traded products creates the risk that some of them may not live up to client expectations, or even break down.

ETFs now track equities, fixed income, commodities, infrastructure, private equity and hedge funds. Some are physically-backed; others use swap-based, synthetic structures to replicate a particular type of return. Certain ETFs also offer leveraged exposure to a market, while others provide bearish investors with short exposure to a market. 

Gutteridge said that long only equity, bond strategies and stock lending pose very little risk, while ETFs that "short" assets or invest in commodities are the most risky.

ETFs that short are often based on daily closing prices, so they can lose value rapidly if the stock market climbs for a sustained period. Gutteridge says volatile reference assets present the greatest risk for this reason.

In terms of commodities, Gutteridge says many investors believe their product will trade in line with spot price movements, but interest rates and "roll yield" mean this is not the case.

A negative roll yield occurs when ETFs sell expiring futures contracts to avoid delivery of commodities and buy more expensive contracts with longer maturities. The ETF therefore loses value each time a contract is rolled.

Changing interest rates also affect collateral, which is stored as margin to avoid purchasing the commodity, affecting the return on initial investments.

Gutteridge stressed the importance of thorough research on the part of investors, because ETF performance may not always meet their expectations. Despite the risks and a lack of transparency on the part of providers, he says, Brewin Dolphin would not describe ETFs as toxic.