ETFs allow investors to buy a share of the market in gold or wheat or any commodity without buying the product itself
One of the most successful investment vehicles of the last decade could be sowing the seeds of the next financial crisis, a global financial watchdog warned.
Pension funds and retail investors could lose billions of pounds in investment schemes sold widely in the US and Europe with the promise of low costs and higher returns than bank deposit rates.
The products have enticed investors into the soaring commodities markets, allowing them to enjoy huge returns from the rising cost of oil, gold and silver in recent years.
The Financial Stability Board, which was created in the aftermath of the financial crisis to monitor financial transactions, said the rapid growth of exchange traded funds (ETFs) into a $1,200bn (�735bn) business was unnervingly like the derivatives market in sub-prime mortgages before the credit crunch in 2007.
Mario Draghi, the chairman of the FSB, said ETFs had all the hallmarks of a bubble waiting to burst and needed close monitoring by international regulators.
"ETFs are reminiscent of what happened in the securitisation market before the crisis," he told an audience at the IMF Spring conference in Washington at the weekend.
Securitisation was widely used by banks to package and resell bundles of mortgages, which buyers repackaged and sold on as mortgage derivatives. The discovery of artificially inflated values for mortgage-backed securities were blamed as a key reason for the crash.
ETFs and index funds have taken about a fifth of the US fund market, attracting investors with lower costs than actively managed mutual funds.
They also offers tax advantages and easy access to markets and industries usually reserved for institutional investors, offering exposure to markets without the necessity of buying the product itself.
This is especially attractive in commodities markets, allowing investors to buy a share of the market in gold or wheat without buying the product itself. The recent rise in the gold price has been underpinned by investors buying ETFs.
According to the Investment Company Institute in Washington, their market share has risen from 8.7% 10 years ago, and they accounted for half of new investments in 2010 with about $750bn invested compared to $250bn in Europe.
Several of the largest equities traded on the US stock market are ETFs, pushing out the more traditional, actively managed mutual funds. As a measure of the increasing dominance of ETFs, earlier this month Vanguard Group, the world's biggest mutual-fund company, said it plans to start selling ETFs in Europe.
Draghi's comments follow mutterings by the UK City watchdog, the Financial Services Authority, that ETFs pose risks to the financial system.
Critics of the products say they are opaque and can carry severe risk, with excessive leverage to increase returns.
They fear ETFs will follow the same path as mortgage-backed securities, with major investment firms mimicking the creation of derivatives from derivatives in the form of collatoralised debt obligations (CDOs).
Svein Andresen, secretary general of the FSB said all areas of trading outside recognised exchanges, so-called shadow banking, was a cause for concern. He said the creation of off-balance sheet vehicles by banks, which were used to trade derivatives, was another factor in causing the crisis, and similar activities must be monitored.
"One of the lessons of the crisis was that we kept a good eye on the major regulated markets but not on others. We need to be in a position to capture that," he said.
The activities of hedge funds and other non-bank financial institutions are expected to come under increasing scrutiny as banks move their activities offshore or beyond the scope of domestic regulators.
The International Monetary Fund (IMF) said in its final communiqu� at the spring conference at the weekend that more co-operation was needed to address risks posed by banks and other large financial institutions.
"We call for enhanced financial sector oversight of risks related to shadow banking activities and agree to maintain momentum to tackle non-cooperative jurisdictions," it said.
Source: http://www.guardian.co.uk/business/2011/apr/17/imf-commodities-funds-sub-prime
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