60 second guide to ETFsUBS rogue trader loses £1.3bn using ETFs

16 September 2011

Understanding tracker funds and ETFs

Trackers and ETFs are lower cost alternatives to actively managed funds

A trader at Swiss bank UBS has been charge with fraud, after allegedly losing £1.3bn through unauthorised trading using exchange traded funds (ETFs). 

UBS were only notified of the fraud when the trader, Kweku Adoboli, 31 from London, notified the bank of what had occurred. The use of ETFs in the alleged fraud has amplified the criticism and scrutiny around the products and how investment banks monitor their use. Their rapid rise in popularity over the past few years has seen global regulators raise concerns about how they are built, how they invest and the risks that come with investing in them.

ETFs are a type of passive investment that now account for £1 trillion of assets all over the world and have been embraced by investors, as they allow you to simply track a stock market index at an ultra low cost. 

Regulatory concerns over ETFs

However, the Financial Services Authority (FSA), Financial Stability Board (FSB) and the Serious Fraud Office have all recently hit out at ETFs, claiming that they could carry risks that investors aren't aware of, the potential for misselling and, as demonstrated by the recent events at UBS, the possible exploitation of fraud. 

With this in mind, Which? Money gives you the lowdown on these investment products, how they work, and the pitfalls you should look out for.

What is an exchange traded fund?

An ETF is a type of collective investment fund, which pools your money in with other investors, to invest shares, bonds and other types of investment assets.

They differ from traditional investment funds like unit trusts and open ended investment companies (Oeics) because they are traded on the stock market and can be bought and sold throughout the day. This provides a greater degree of flexibility to these investments.

ETFs are passive investment funds – meaning that the simply track a particular stock or bond market index. Therefore, they are much lower price than actively managed funds.

How do ETFs track a stock market?

There are two principle ways that ETFs track a stock market. The first, and most straight forward way is through a process called 'physical replication'.

This means that the fund buys all the shares in the stock market index, in proportion to their size. For the FTSE 100 (the index that measures the performance of the 100 biggest company shares in the UK), it will buy all 100 shares, based upon how much of a stake they have in the index. This way, the fund can accurately return whatever the stock market is paying.

When a stock market is really big (like the MSCI World, which has more than 1,700 companies in it), some ETFs 'partially replicate' the index. The funds invest in a sample of shares that broadly represents the index to try and mimic it. However, sometimes it might not track completely accurately.

What are synthetic ETFs?

Synthetic ETFs are the second way of tracking the stock market. Instead of buying shares in the stock market you want to track, synthetic ETFs enter into an agreement with a third-party investment bank to swap the performance of one set of investments for the performance of the stock market.

The ETF will buy some investments like shares and bonds, chosen by the third party bank and unrelated to the index you want to track, and pay them the performance of that basket of investments in exchange for the stock market performance your ETF is tracking.

This agreement uses a derivative called a 'swap'. The third party bank is known as a 'counterparty'.

Is this why regulators are concerned about ETFs?

Yes, this is one of the reasons. If the counterparty providing the 'swap' fails or goes bust, you could lose some, or all of your money. Regulators are concerned that investors don't know enough about this when they put their money into ETFs. And the use of third party banks in this way of investing means that you don’t get any coverage from the Financial Services Compensation Scheme if it does go to the wall.

Regulators are also worried about the investments that synthetic ETFs hold and pay to the counterparty in exchange for the performance of the stock market. It's known as collateral, so if the counterparty does go bust, the ETF can sell the investments to try and return some money to investors.

But there are concerns that the collateral isn't good quality or valuable or even might be difficult to sell in times of crisis. Again, regulators don't think that people investing in synthetic ETFs know about this.

The SFO is particularly worried that ETFs, which have rocketed in popularity, could be a target for fraudsters.

Are there any other problems with ETFs?

Some ETFs can be leveraged, meaning that you earn more than what the market is paying, or can go short, which means that you profit from falling markets. But if the markets don't go the right way, you could lose a lot of money.

We're concerned that investors might think that they're investing in a simple 'tracker' type fund and end up in one that is far more sophisticated.

Should I invest in ETFs at all?

Whenever you're thinking of investing your money, you should always go and seek financial advice. You can find a fully authorised adviser by reading our guide to choosing a financial adviser.

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