Are Certain ETFs Socially Irresponsible?

 

Laurence D. Fink, chief executive officer of BlackRock Inc., blasted sellers of synthetic (derivatives-based) exchange traded funds as damaging to the industry, according to InvestmentNews (“BlackRock’s general, Societe Generale in ETF ‘street brawl'”). BlackRock is the world’s largest ETF provider and one of the world’s largest money managers.

Synthetic exchange traded funds do not own the assets they purport to track, but instead own a derivative (e.g., an option or swap) on the underlying assets. Traditional exchange traded funds own the underlying assets they track.

Derivatives introduce layers of complexity, lack of transparency and counterparty risk. Most investors do not understand the risks of synthetic exchange traded funds.

In Europe, synthetic exchange traded funds were hit with $1.86 billion in withdrawals in October, compared with $3.11 billion deposits for non-synthetic funds.

Referring to one of BlackRock’s competitor’s synthetic exchange traded funds, Fink was quoted as saying: “If you buy a Lyxor product, you’re an unsecured creditor of SocGen,” adding: Providers of synthetic ETFs should “tell the investor what they actually are. You’re getting a swap. You’re counterparty to the issuer.” If the issuer defaults, the investor could lose his or her entire investment.

BlackRock has urged regulators to require more disclosure by synthetic exchange traded funds and to ban the use of the term ETF for those funds, to protect the reputation of the industry in which BlackRock operates.

In response to Fink’s assertions, a Lyxor spokesman countered that physical ETFs like those sold by BlackRock “expose their holders to undisclosed levels of counterparty risk to typically undisclosed counterparties. The unregulated use of securities lending has resulted in meaningful losses in the past.”

The U.K. Financial Services Authority has expressed concern over synthetic exchange traded funds’ counterparty risk and the quality and liquidity of their collateral. The International Monetary Fund and the Bank for International Settlements also cautioned about the risks of synthetic exchange traded funds.

Leveraged and inverse exchange traded funds are synthetic funds that use leveraged to multiply returns (or losses) up to three times the tracked asset. BlackRock’s Fink compared leveraged ETFs to the extreme and exotic financial products created by Wall Street that led to the collapse of the U.S. mortgage market. Fink said he was surprised that some of them were approved by U.S. regulators.

“I do believe we have some responsibility for making sure that the market does not morph itself, the same way when I started in the mortgage market 35 years ago, watching a great market morph into a monster,” Fink was quoted as saying.

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