Lights and Shades of the ETF

Exchange Traded Funds (ETF) are designed to track a benchmark. ETF facilitate asset management and contribute to reduce management fees and transaction costs, they are traded like stocks at current price on continuous markets and meet an increasing success. Initially, an ETF was a stock index-tracking fund and with a full replication approach, the fund included all index constituents in the weightings defined by the index. Currently, underlying extend to all the asset classes, of which commodities or volatility but also strategies: inverse ETF try to achieve the opposite performance or leveraged ETF that seek to magnify the performance of the indexes they track. Baskets of commodities or a single commodity as gold or wheat are benchmark’s candidates. The physical replication (quasi-replication indeed) always has its partisans with security lending generating a complementary income, but synthetic replication (swap-based ETF) is spreading in Europe.

While offering similar exposures, these products may vary significantly in their structures and risk profiles. The differences between structures can bring additional risks to those of the underlying: counterparty risk, conflict of interest. The replication of particular benchmarks (metals, agricultural commodities) raises some questions about price manipulations: can the ETF’s trading destabilize the underlying markets? An improvement of the European transparency regulation would facilitate, from the investors’ point of view, risk-adjusted performance measures of these products.