Risks of synthetic ETFs


In a blog post last year, I discussed how index-tracking ETFs don’t necessarily invest in the shares of the companies that make up that index. Instead they hold a basket of shares as collateral, and use “equity-linked swaps” to make their performance match that of some target index. It all looked a bit fishy to me, and now it appears that other folks who understand this stuff way more than I do feel the same way.

According to a CityWire article, The Bank of England says that synthetic ETFs spell danger, and that  ‘An investor is not just exposed to the index that he or she thought they were exposed to but also to the counter party risk of the institution.’

Great. It’s risky enough being exposed to the stock market. Who needs exposure to institutional risk as well? Even before 2008, it was pretty clear that banks could fail. In 1995, Barings Bank failed due to the actions of just one reckless and over-ambitious trader.

Meanwhile a recent article in the Economist lists a variety of risks and complications that most ETF investors are blissfully unaware of.

Over the past couple of years, I’ve bought and sold various ETFs with no problem, and I still have some money in ETFs. They still seem like the best way to get some diversification, especially exposure to markets that might otherwise be difficult to invest in. For example, there’s no way I could possibly by shares in all companies in the S&P 500.

However, given the complicated structure of some ETFs and the risks now being exposed, I’m now definitely going to be more careful. You should be too…

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About Gerry Beauregard

I'm a Singapore-based Canadian software engineer, inventor, musician, and occasional triathlete. My current work and projects mainly involve audio technology for the web and iOS. I'm the author of AudioStretch, an audio time-stretching/pitch-shifting app for musicians. Past jobs have included writing speech recognition software for Apple, creating automatic video editing software for muvee, and designing ASICs for Nortel. I hold a Bachelor of Applied Science (Electrical Engineering) from Queen's University and a Master of Arts in Electroacoustic Music from Dartmouth College.
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