Exchange traded index funds (ETFs) have many advantages. But no product class is without its disadvantages – not even ETFs. Investors should, however, take a close look before buying an ETF. Because even with these generally inexpensive products, not everything is as simple as it seems at first glance.
Counterparty Risk of Swap ETFs
When entering into a swap agreement, what is known as a counterparty risk arises: the ETF depends on the swap partner (the counterparty) fulfilling its obligations. However, if the bank slips into insolvency, the ETF will be left with any existing claims from the swap contract – and the investors’ money is gone. Because: The swap is not part of the fund.
In addition, the various ETF providers take precautions to reduce the counterparty risk. For example, the swap partners are sometimes obliged to provide collateral for their obligations that exceeds the actual value of the swap. As a rule, however, these collateral obligations are not anchored in the sales prospectuses. Investors should therefore not rely entirely on these promises.
Some providers prefer to use contracts with different banks instead of collateral for the swap agreements to limit the risk of failure of a single contractual partner. It is difficult to quantify the benefits of these so-called multi-counterparty structures for investors.
Swap ETF costs
Another problem: investors cannot understand the fees for the swaps. Since swaps are not exchanged on exchanges but are agreed fairly between the parties to the deal. Since ETF providers are often part of giant banking groups and conclude swap agreements with their parent companies, there is a risk that investors will be harmed by excessive fees.
Instead of these problems, however, providers prefer to focus on the alleged advantages of swap ETFs: the uncomplicated mapping of complicated indices and the cost savings – also for investors. In fact, the risks and problems mentioned do not have to speak against buying swap ETFs. But by acquiring a synthetic replicating ETF, everyone should know what they are walking into.
Costs and Risks of Physically Replicating ETFs
ETFs that physically replicate, i.e. actually hold the securities contained in an index in the fund’s assets, have their pitfalls. Virtually all companies reserve the right to lend the securities owned by the fund. The borrowers can, for example, be speculators who bet on the fall of a certain share and therefore want to sell it short.
In order to borrow this stock from the ETF, you must pay a fee to the fund. Securities lending creates additional income for investors. First of all, that’s positive – after all, it improves the return on your investment.
However, there are also problems with this. For one thing, there are no higher returns without higher risk. And so the lending fee is ultimately a compensation for the risk that the ETF takes by giving up the securities. Because: If the borrower becomes insolvent, the ETF may not get the papers back. The ETF providers try to hedge against this by lending securities only against collateral. However, this also does not guarantee 100% protection.
Perhaps the bigger problem, however, is that while investors have to bear the full risk of the securities lending business, they only receive part of the income. The ETF providers usually grant themselves the right in the sales prospectuses to keep 50 percent of the income from lending transactions for themselves.
Conclusion: ETFs are an interesting alternative to actively managed funds, but they have certain pitfalls that you have to be aware of
Even if ETFs have many advantages over actively managed funds, consumers must also take the disadvantages outlined above into account before deciding to buy. But despite these weaknesses, ETFs do well in direct comparison with actively managed funds – and even relatively transparent. And the disadvantages of ETFs also partly apply to actively managed funds – because they too use derivatives or conduct securities transactions, for example.