Physical ETFs: A Call for Transparency

Ironically, we believe that today as it pertains to counterparty risk there is greater transparency on swap-based ETFs than on physical ETFs

Hortense Bioy, CFA 22 September, 2011 | 2:54PM

A flurry of warnings from global financial regulators in the spring of 2011 highlighting potential risks within and posed by exchange traded products (ETPs) caused quite a stir in the industry. Many responded by saying that regulators’ concerns were overblown either because ETPs represent a very small part of the market or because a lot of the risks that were identified are non-specific to ETPs. Nonetheless, the great majority of market participants welcomed the call for greater transparency surrounding certain practices. Leading providers acknowledged the importance of disclosing more information on both synthetic and physical ETPs so investors can make better informed decisions.

Among the potential risks that were highlighted by the regulators, counterparty risk is one that we, at Morningstar, have never failed to remind investors of through our reports, articles and webinars. Following the publication of a comprehensive report on the mechanics of swap-based ETFs and the risks associated with them, we thought it was only fair that we re-address the risks embedded in physically-replicated ETFs that engage in securities lending.

Securities lending, also known as sec lending or stock lending, is the process of loaning securities to a third party in exchange for a fee. The borrower, typically a hedge fund or other short seller, hopes to profit from a decline in the price of the securities.

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About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive funds and sustainability research in Europe for Morningstar

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