Investors don’t understand the risks of physical ETFs

New research reveals little knowledge of counterparty risk.

April 3, 2012

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road sign carFinancial authorities have been all over the risks embedded in synthetic ETFs – but a recent European survey shows that investors are largely unaware of the risks inherent in physical ETFs.

Last week, the EDHEC Risk Institute released the results of its European ETF survey based on 174 European ETF investors. One of the most surprising findings is that most investors think that full physical replication is less risky than synthetic replication in terms of counterparty risk. This in spite of the fact that nearly all physical replication ETFs actually do engage in securities lending.

At worst, this finding highlights the fact that a lot of investors – some sophisticated ones at that – lack a basic understanding of how ETFs operate. At best, the survey shows regulators are on the right track when it comes to proposals that improve ETF transparency, not just for products that rely on synthetic replication, but on the physical side too. Notably, investors do prefer to go the physical route according to the survey (the survey shows they favour this approach over sampling or synthetic replication).

Regulatory proposals that call for better disclosure and transparency will go a long way to closing the information gaps in the rapidly growing ETF space, but investors also have a job to do in asking questions that improve their basic understand of how these structures operate. They need to get into the habit of kicking the tires on what they plan to buy in the ETF space, otherwise, they could end up with the wrong kind of vehicle (do you want a minivan or a racing car?). No amount of regulation can motivate investors to look under the hood, but a good dose of education in the marketplace is a good start.

Other findings from EDHEC include:

  • Investors are also moving towards applying ETFs for portfolio optimisation and risk management, and continue to see ETFs mainly as index-replicating products, rather than active funds.
  • Investors acknowledge that the current education on the differences between highly regulated ETFs and largely unregulated ETPs needs to improve in order to avoid confusion.
  • While investors are using ETFs more heavily for dynamic strategies and specific sub-segment exposure than in the past, the main use of ETFs remains long-term buy-and-hold investing in broad market indices.
  • ETFs are mainly used as beta or asset allocation tools, thus allowing investors to focus on the first-order issue of beta management, rather than on stock picking issues, which are only of third-order importance.
  • There has been increasing demand for ETFs based on new forms of indices, from 29% to 39% over the past year, which indicates growing interest in alternative-weighted indices.
  • ETFs remain very popular for passive investment. In terms of future use, a majority of respondents (63%) indicate that they intend to increase their allocation to ETFs in the future.

You can find full survey results here.

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