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New EDHEC-Risk Institute research assesses the true risks of ETFs

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New research at EDHEC-Risk Institute has addressed the question of the true risks of Exchange-Traded Funds (ETFs) in Europe in the light of issues raised by financial regulators and international organisations.

According to EDHEC-Risk Institute, any discussion of the risks inherent in ETFs should go beyond merely hypothesising about potential risks, and should also take into account the empirical evidence provided by the existing academic research on ETFs, which has documented various benefits in terms of liquidity and price efficiency.

Among the conclusions of the EDHEC-Risk Institute study:

The vast majority of European ETFs are managed within the UCITS framework and as such have the same levels of security and the same risks as any UCITS fund. Highlighting the supposed risks of ETFs therefore makes little sense, and even less so in matters of retail investor protection in that ETFs represent but a fraction of the products sold to the general public in Europe and competing investment vehicles typically do not benefit from the same level of protection as that provided by the UCITS framework.

The massive marketing and media relations campaigns implemented by some ETF providers in an effort to promote counterparty-risk-based distinctions between physical and synthetic replication ETFs are misleading.

As far as counterparty risk is concerned, it makes little sense to oppose physical replication and synthetic replication products on the one hand, or draw a fine line between unfunded and funded swaps on the other. Both distinctions are largely irrelevant in practice and convey a false sense of "comparative" safety. In fact, whatever the replication techniques employed, ETFs are exposed to counterparty risk. As a matter of fact, securities lending is widely practiced by physical replication ETFs and leads to counterparty risk, just as surely as the reliance on over-the-counter derivatives by synthetic replication ETFs. Investors should pay more attention to first order issues that determine the effective mitigation of counterparty risk: the level of collateralisation, the quality of the assets performing the economic role of collateral and the ability of the fund to enforce its rights against collateral in the case of default by the counterparty.

The issue of counterparty risk should be addressed through clear guidelines on counterparty risk mitigation up to the quality, marketability and diversification of assets performing the economic role of collateral and these should apply irrespective of the manner in which counterparty risk is assumed or mitigated, and to all UCITS and competing investment vehicles.

Transparency should not be restricted to the problems posed by counterparty risk and its mitigation, but should include disclosure of the revenues and costs from ancillary activities such as securities lending. Last but not least, it is curious that while most ETFs are passive investment vehicles tracking indices, there is no standardisation or mandatory information on tracking error risk today in the European regulations. In the same way, regulators should give a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes, which remain the main drivers of the financial risks assumed by ETFs.

 

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