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What are structural risks with ETFs?

08 October 2019 | Portfolio construction

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As the ETF market continues to grow, investors are questioning how secure their ETF holdings are. We outline some of the key points they should consider.

The rapid growth of the exchange-traded fund (ETF) market in recent years has benefitted many investors, giving them low-cost access to a range of markets.

But with this growth has come greater scrutiny. As the variety of products expands, investors are delving deeper into the inner workings of ETFs.

Many are questioning how secure the ETFs offered by some providers are. For example, what underlying assets make up the ETF? Are those assets safe? What counterparty risk does a provider pose?

At Vanguard, we refer to these as structural risks, and it turns out that some ETFs carry greater risks than others.

Replication method – physical or synthetic?

When questioning what assets an index ETF is actually investing in, investors should look at the replication method. Physical ETFs have a reasonably straightforward and transparent replication methodology: they hold all, or at least a representative sample, of the underlying securities that make up the index.

Synthetic ETFs, on the other hand, use swaps to track their benchmark, meaning they can track an index without actually owning any of its securities. Synthetically replicated ETFs can allow investors to access otherwise inaccessible markets and less liquid benchmarks that could be difficult for physical ETFs to track.

But synthetic ETFs also expose investors to counterparty risk, because the derivative contracts they rely on are agreements between the ETF and a counterparty to pay the ETF the return of its index. Investors in synthetic ETFs therefore trust that the swap provider will fulfil its obligation to pay the agreed-upon index return. Investors in physical ETFs are not exposed to the same counterparty risk.

Securities lending – how much and who benefits?

ETF providers do not always leave an ETF's underlying assets to sit idle. Often they engage in a practice known as securities lending, whereby funds make short-term loans of securities they hold, secured by collateral, charging the borrower a fee to borrow the security.

This can be a productive way of using underlying securities to generate additional revenue for fund investors (and in some cases, for the provider). But it can also subject investors to risks, and there are different methods of securities lending that entail differing levels of risk for the end investor.

The value-oriented approach is the most conservative, and involves lending only a small proportion of the fund's shares, which may boost returns for investors without undertaking undue risk. The alternative approach is volume-based securities lending; this method generally focuses on aggressive collateral reinvestment and the loan of more securities, and it also carries greater risk for investors.

Investors should check the ETF provider's approach to securities lending, including what proportion of assets they are willing to lend, and whether it matches with their approach to risk.

ETF providers can also differ considerably in the proportion of securities-lending revenues they return to fund investors. Another check for investors is asking how much of the revenue is being returned to the fund.

Liquidity – consistent with investor requirements?

An unintended side-effect of the huge growth of indexing and ETFs is the emergence of a number of esoteric products, some of which are thinly traded, lacking in liquidity or leveraged.

A key consideration for investors should be to ensure that their liquidity requirements correspond to the characteristics of the underlying assets. For example, if an investor requires a high degree of liquidity, they could consider those ETFs that provide exposure to highly liquid and diversified markets; these are the markets where investors can transact in a transparent and cost-effective manner.

Digging deeper

Beyond these risks, there are other points to consider. What regulatory safeguards are protecting investors' ETF positions? Is the ETF provider aligned to investors' interests? A fund manager's ownership structure, for example, can give insight into how well aligned the manager may be to the interests of their fund investors. 

Does the provider have a track record of index-tracking performance? Accurately tracking a benchmark is harder than it looks, and some providers are able to track indices more closely than others.

Investors are right to be concerned about these kinds of risks. But by exploring these points with a provider, they can have greater confidence when investing in an ETF.

To read more about these structural risks, click here.

Related

Find out more about low-cost ETFs

 

Important risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Other important information:

This material is for professional investors as defined under the MiFID II Directive only. In Switzerland for institutional investors only. Not for public distribution.

This material was produced by The Vanguard Group, Inc. This article is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

The opinions expressed in this article are those of the author and individuals quoted and may not be representative of Vanguard Asset Management, Ltd or Vanguard Investments Switzerland GmbH.

Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority. In Switzerland, issued by Vanguard Investments Switzerland GmbH.

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