A warning about Exchange Traded Products

The Financial Services Authority (FSA) has published a factsheet for advisers highlighting some of the risks when recommending Exchange Traded Products (ETPs).

Whilst this is currently a small market for UK investors, it is expected to grow very quickly. The FSA has been reviewing the risks posed by ETPs and their factsheet is aimed to help raise awareness about these risks.

ETPs are similar to company shares in that they are quoted and traded on stock exchanges. The price of the ETP share determines the value of the investment.

An Exchanged Traded Fund (ETF) is one example of an ETP.

They are designed to track the price of a particular financial index or benchmark, such as the FTSE 100 index of leading UK company shares.

One of the most significant risks associated with ETPs is the transactions they sometimes undertake with third parties. This can include using derivatives or lending stock to a third party.

The FSA points out that the features of ETPs vary by market, investment strategy, legal structure and risk. This means that each ETP needs to be carefully scrutinised before investing, to ensure all of the risks are fully understood.

An important feature to understand is the replication strategy of the ETP. This is how the manager aims to replicate returns from a chosen financial index or benchmark.

Some ETPs use physical replication, which means it actually buys the underlying shares which make up the index. Others use synthetic strategies, where financial instruments are used instead to replicate the target returns.

In our opinion, investors should pick their ETPs carefully and understand the main features before investing.

Our preference is to only recommend Exchange Traded Funds that comply with the UCITS directive, use full physical replication, invest in liquid and well established markets (such as the FTSE 100 or S&P 500), have fully segregated liabilities, and offer UK tax reporting status.

We have real concerns about the suitability of some ETPs for retail investors, particularly those investing in niche markets and those that provide inverse returns.

Leveraged ETFs are another type of product that we believe are generally unsuitable for retail investors.

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