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Experts warn of hidden danger of complex investments

By Michael Robinson
File on 4, BBC Radio 4

image captionExperts warn of the threat to the system of overly-complex financial derivatives

Despite concerns about their role in the financial crisis, many experts are worried about about the re-emergence of increasingly opaque investment products.

Warren Buffett famously called them "weapons of mass destruction", and policymakers damned them for their part in the 2008 crash.

But in Britain and elsewhere, complex financial derivatives are once again thriving.

Take one of the fastest growing and most popular ways for people to invest their savings, the "exchange traded fund" (ETF).

ETFs began as a simple enough product - a cheap and convenient way for individuals or pension funds to invest in the performance of a stock market index such as the FTSE100.

Early ETFs needed little financial engineering. Investors bought shares in an ETF, and the ETFs' managers bought shares of the companies in the index their ETF had promised to track.

Just over half the ETFs sold in Britain are still like that. In the trade these are known as "plain vanilla".

But, following the 2008 crash, large investment banks - mostly European - started heavily promoting ETFs of a very different flavour, called "synthetic" ETFs.

To all appearances, synthetic ETFs look much the same as the original kind. But inside, they are completely different because they are based on complex derivatives.

At Hermes Fund Managers, one of the biggest pension fund advisers in Britain, the head of investment Saker Nusseibeh told File on 4, "I think synthetic ETFs look too good to be true".

Saker Nusseibeh and his team oversee investment for the giant BT pension fund and a string of other large funds. He despairs at the re-emergence of financial complexity.

"We are in the only industry that likes complexity," he said.

"In art or in science, the crowning rule is, 'the simpler it is the better'.

"It seems we have done exactly the opposite - the more complex a thing is, the better it is perceived to be.

"If we are making it further complicated, I question the motivation," he added.


Regulators are beginning to do the same.

Over the past year, financial overseers in Britain and in Europe have started examining the structures of typical synthetic ETFs and they have been increasingly critical of what they have found.

For example, most synthetic ETFs do not invest at all in the shares of the index they say they are meant to track.

Instead, investors' money goes from the ETF to an investment bank.

And in return the ETF gets a promise that the bank will pay over to the ETF whatever return the index would have delivered. This, in financial jargon, is called a "swap".

If the bank can use investors' money to make more profit than it has to pay out on its promise to match the ETF's index, the bank is ahead.

This is not the end of the complexities.

To safeguard investors, investment banks also put up a basket of collateral against their swap which most banks say will always be worth more than the money they owe an ETF on the index it tracks.

Former fund manager Paul Amery, who runs the website, took me through the vast range of synthetic ETFs on offer from Deutsche Bank - one of the leading providers in Britain and Europe.

Deutsche Bank's 'db X-tracker FTSE Vietnam Index' says it will track the performance of a range of Vietnamese companies.

But, as Paul Amery showed me on the fund's website, the basket of collateral investors get from Deutsche Bank was holding no Vietnamese shares at all.

Instead it contained shares and securities from Germany, America, Japan, Sweden, Austria, France, Canada and elsewhere.

"This is the way synthetic funds operate. You have a basket of assets that may be completely unrelated to the assets you are tracking," he explained.

That mismatch concerns the Bank of England. In the latest Financial Stability Report (pdf), published last month, it says investment banks promoting synthetic ETFs might have an incentive to use collateral baskets of their ETFs to "fund illiquid portfolios".

In plain language, that means investment banks could offer as collateral shares or other financial instruments they already hold on their books but which are relatively hard to sell or value.

Doing that would effectively change those hard-to-sell, illiquid assets into cash.

The academic and author John Kay says this matters because it is the ultimate surety ETF investors have. He says he feels a sense of déjà vu from the collateral issue.

"'Everything is collateralised' is a story we have heard before," he told me.

"The problem is that when things get tough in the way they did in 2007 and 2008, how sure can we be that these contracts are actually going to work as well as they are intended to?

"When you start working through the complexity of these transactions, you start to get scared."

Investigating synthetic ETFs for File on 4 was a mental marathon. No sooner did we think we had understood one set of complexities, than yet another turned up.

For example, we came across a soon-to-be published academic paper from American fund manager Brendan Connor.

This highlighted long chains of transactions between investment banks, ETF providers and hedge funds in which ETF shares were lent, borrowed and sold.

image captionWarren Buffett warned against the "mega-catastrophic risk" posed by derivatives in 2003

Mr Connor says he and his co-authors believe this is another serious source of potential instability. And he says it is even more worrying because it is far from clear that all the participants in these chains are strong enough to deal with times of stress.

"It's not just large banks that are participating in the creation of ETFs," Brendan Connor says.

"There are also a large number of marginal participants that plainly do not have the capital to support this sort of activity.

"They are clearly in no position to support an ETF in the event that it actually collapsed. We think it's only a matter of time before something like this happens."

But who gains from this mind-numbing complexity?

The large, mostly European investment banks offering synthetic ETFs say they offer investors a better deal than plain vanilla ones.

A table in the Bank of England's Financial Stability Report illustrates that.

'False sense of security'

Comparing the expenses of synthetic and plain vanilla ETFs tracking major global stock market indices, it shows that investors do benefit. But not by very much.

The biggest saving which some synthetic ETFs seem to offer is around 0.2% per year. With the other major indices illustrated, the advantage is less or non-existent.

So how profitable are synthetic ETFs for the investment banks promoting them?

Unfortunately, because of the complexity and opacity of investment banking, that is not a question an outsider can answer.

But the explosive growth of synthetic ETFs in recent years is a strong clue that many large investment banks have found them extremely profitable.

Is the complexity inside synthetic ETFs worth the additional risk? Investment banks clearly think it is.

But back at Hermes Fund Managers, Saker Nusseibeh has doubts about the wider usefulness to society of doing something as simple as investing in a stock market index in such an extremely complex way.

"We've been here before. Over the last 20 years as we have used more and more complex instruments there is a perception that we understand risk better because we have better computer models," said Saker Nusseibeh.

"And I think these models actually give us a false sense of security. If anything, the lesson of 2008 is that we understand risk far, far less."

File on 4 is on BBC Radio 4 on Tuesday 5 July at 2000 BST and Sunday 10 July at 1700 BST. Listen again via the BBC iPlayer or download the podcast.

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