Much has been made of the potential problems – and even systemic risk – that exchange-traded funds may pose to the financial markets. Yet such concerns may be overdone, argues Kelvin Blacklock, CIO for global asset allocation at Eastspring Investments, recently rebranded from Prudential Corporation Asia.

Singapore-based Blacklock views ETFs as a cheap and efficient way of implementing tactical views and getting market access, although he admits that sometimes it’s not appropriate simply to buy the market. In credit, he notes, the benchmark may be skewed – for example, a market-cap-weighted European government bond index is likely to contain a lot of Italy. In such cases, an actively managed bond fund would probably be a better choice.

But what about synthetic – or swaps-based – ETFs? It has been suggested that such instruments, particularly those involving heavy leverage and created by inexperienced providers, could result in a blow-up that harms the industry (see AsianInvestor’s ETFs & Indices Report, September 2011, pages 10-12).

“I suspect people are a bit overly concerned about [the potential issues], but I’m very sympathetic to the concerns,” says Blacklock, who oversees Eastspring's $28 billion in global multi-asset portfolios, which largely comprises the firm's life insurance general account.

“People tend to shy away from swaps-based products because they introduce an element of complexity," he adds, "and you suffer a very, very small potential risk of some counterparty credit risk. It’s difficult to explain all that to investors who just want to get cheap access to a market.”

In fact, he argues, some of the synthetic ETFs work better than the cash-based ones, because they effectively pass on the tracking error to someone else. “So as long as you trust that person or entity to be around and continue to operate in good faith as a sensible business, you should actually get a better result.

“It’s a question of caveat emptor,” argues Blacklock. “As long as you understand them, assess them and do a proper comparison – looking at liquidity, at tax advantages, underlying fat-tail risk of the counterparties etcetera – then you should make a sensible choice.”

He doesn’t use more complex ETFs, such as those that provide leverage on or short the underlying assets, because Eastspring is a cash-based investor with no need for leverage and a fairly long time horizon. But again, he says, as long as the buyer is aware that these products will likely not provide exactly twice or half the market return, due to daily compounding, then there’s no reason not to use them.

“It’s like anything – the problem is to set rules and parameters that mean that people who shouldn’t be playing in that market don’t get hurt,” notes Blacklock.

Still, it may be that such products should be restricted to sophisticated investors or that there should be a minimum initial investment threshold, he adds. “That’s the job of the industry and regulators. It’s a challenge for them to decide how these things should be packaged and sold.”

Deborah Fuhr, former head of ETF research at BlackRock and now a London-based independent ETF strategist, made similar points in a recent interview with AsianInvestor. There has been a lot of unfounded scaremongering and accusations levelled at ETFs, she argues, but nonetheless investors should ensure they are fully aware of what they are buying.

“You have many types of synthetic ETFs out there – sometimes they only have one and sometimes multiple swap counterparties; sometimes they are funded, sometimes unfunded,” she notes. “So there is an onus on the end-investor to understand the different types of products.

“The challenge is that if you look at many providers, they often have many different types of ETFs being domiciled in different places, sometimes they offer both ETNs [exchange-traded notes] and funds, they offer synthetics, physical, swaps-based, p-note based, etcetera, so you cannot assume [what is underlying the products] without doing your homework.”