This is a topic I should have paid more attention to earlier: systemic risk in ETFs (Exchange Traded Funds). Here are my thoughts in a few bullet points:

• ETFs are a great idea. They allow diversification at minimal cost to the investor (especially compared to mutual funds).
• Unfortunately, the financial  industry is in the process of pushing the limits on how ETFs can be abused.
• Warnings on systemic risk have been issued by the IMF, BIS and G20.
• Here are some of the risks:

1. Synthetic replication: The ETF does not actually purchase the promised investment exposure (e.g. gold), but “replicates” the exposure synthetically by entering swap agreements with an investment bank. Should the bank go belly up, there is no exposure. “Paper gold” might not be enforceable.
2. Funding: many ETFs are actually structured derivatives (zero coupon bonds with derivatives attached) allowing the issuer to use investor’s money for their own funding purposes. The investor has, as seen with Lehman “guaranteed” equity-linked certificates, an issuer risk.
3. Securities lending: ETFs generate income through securities lending. This creates counterparty and collateral risk in case the counterparty goes bankrupt and the securities are not retrievable.
4. Rehypothecation: Hypothecation is the practice where a borrower pledges collateral to secure a loan. Rehypothecation is a practice where a bank or other broker-dealer re-uses the collateral pledged by its clients as collateral for its own borrowing. In 2007, rehypothecation accounted for half the activity in the “shadow” banking system. Because the collateral is not cash it does not show up in conventional balance sheet accounting. Prior to the Lehman collapse, the IMF calculated that US banks were receiving over $4 trillion worth of funding by rehypothecation, much of it sourced from the UK where there are no statuary limits governing the reuse of a client’s collateral. It is estimated that only $1 trillion of original collateral was being used, meaning that collateral was being rehypothecated several times over.

Conclusion:

• Abuse of ETFs by the issuer (and possibly by high-frequency traders) is obvious.
• It is not only possible but likely that one day an ETF will fail because of counterparty or collateral issues.
• This could lead to a panic reaction, leading to a situation where even physically backed ETFs could trade at a discount to NAV (net asset value).
• This means that for our client portfolios we will not use ETFs going forward (except if the client explicitly wants to do so). One exception is the precious metals area, where the transaction and storage costs are too high to invest directly in physical gold. There are a few physically backed ETFs (e.g. by Sprott Asset Management in Canada) we have enough confidence in to invest (it is not without reason they trade at a premium to NAV).
• It is debatable if ETF’s should be used to establish a short market position (e.g. as a hedge). Leveraged ETF’s are shown to be guaranteed losers over time. Even ETF’s aiming to replicate inverse daily price changes have suffered performance drag over longer periods of time. Their advantage: if the investor is wrong in his assumption his position gets smaller, not larger (as in a “real” short position via futures or short sale).
• Current holdings, like in mining stock ETFs, will gradually be exchanged into the 3-7 largest underlying holdings. We still have to figure out if those holdings will be equally weighted or market capitalization weighted.

As uncomfortable as giving up ETFs might be, I am afraid this is in the best interest of our investors.