Analysis: Warnings mount as retail ETF surge gathers pace

LONDON (Reuters) - Worries over opacity and liquidity could temper small-time savers' enthusiasm for Exchange Traded Funds (ETFs), set to be boosted by a UK regulatory revamp of fees on products sold to private investors.

Retail investors are flocking to ETFs, which typically track baskets of shares, bonds or commodities and are traded like stocks. Assets under management of ETFs traded on European exchanges rose 43 percent to 183 billion euros ($230.8 billion) in June, according to data from Thomson Reuters funds research group Lipper.

But critics warn that some of these funds -- originally designed for sophisticated institutional investors -- hold hidden risks and often lack the transparency touted as a key selling point.

"There isn't a regulatory definition of ETF. In the institutional marketplace people ought to be able to take the due diligence so it's not necessarily an issue but in the mass retail market you are in a different place," said Julie Patterson at the Investment Management Association, which represents the British funds industry.

British watchdog the Financial Services Authority (FSA) has gone so far as to explicitly recommend their use, as part of its effort to move to a model where advisers charge clients, rather than pocketing commissions from fund firms.

And providers of ETFs believe retail investors, many of whom are disgruntled with performance over the last few years, will soon account for up to half the market in Europe, where they currently represent around 30 percent.

"If you get the shift to a fee based system in Europe, that split between institutional and retail will end up in the same ballpark as the U.S. market," said Nizam Hamid, head of sales strategy at BlackRock's ETF arm iShares' Europe.

But investors could quickly find themselves exposed to complex and opaque packages of synthetic securities as they venture deeper into the ETF market, and the Bank of England has warned people not to get carried away by their success.

"One risk is that the benefits of ETFs become outweighed by complexity, opacity and contingent risks... It is important that the industry does not overreach when innovating in the ETF arena," it said in its Financial Stability Report.

While most ETFs hold straightforward baskets of assets, some also hold derivatives of the underlying securities, including swaps, futures and options, and seek to outperform the index they track.

Many ETF providers also lend both shares in the fund and the underlying securities to investors, such as hedge funds, who want to take short positions and bet on a falling price. The Bank of England raised questions about transparency surrounding the practice.

BOOM RISK

One potential pitfall identified by the central bank is that in volatile markets, liquidity in the underlying securities could stall potentially opening up a large gap between the value of shares in the fund and the assets it tracks.

ETFs are three-tiered constructions in which product providers such as Blackrock's iShares and Deutsche Bank sell ETF shares through middlemen -- often investment banks -- who can also function as market makers.

The middlemen, known as authorized participants, also provide the underlying security needed to construct the ETF, which the product provider deposits with the fund.

"Market makers are not obliged to make markets at all times so may withdraw liquidity in volatile markets," the Bank of England said in its recent report.

Low-cost ETFs have their attractions, particularly in still jittery markets where few investors dare take extra risk in the hope of outperforming the market -- something that ETFs weren't designed to do, because they track indexes.

The average annual fee on ETFs stands at around 33 basis points, compared with 146 basis points for active funds, according to BlackRock.

An outspoken proponent of the funds for their cheapness and efficiency is Alan Miller, former fund manager at Jupiter and founder of SCM Private, a London wealth management firm that invests in portfolios of ETFs.

"If you look at the odds, you can get a better spread of assets, pay a lower fee and get a higher return," he said.

The critics acknowledge these advantages but stress the dangers some products may pose to the uninitiated.

"Tradtional ETFs are sound products and have been around a long time and provide good value... The issue is about a lack of proper disclosure about what (the ETF) is. Whenever there is opacity, that's where there can be a problem," said the Investment Management Association's Patterson.

(Editing by Douwe Miedema and Sitaraman Shankar)