Terry Smith Warns (Again) On ETFs

Last Updated: 16 April 2024

Terry Smith, founder of asset manager Fundsmith, has criticised ETFs in his latest blog, suggesting that the breakneck pace of development in the exchange-traded fund market is creating excessive risks. “I just wonder whose neck will eventually get broken,” warns Smith.

Fundsmith, Smith’s new asset management venture, is targeted at retail investors and aims to offer low-cost active management. Smith—formerly a leading city analyst, author and CEO of broker Tullett Prebon—warned of potential mis-selling risks in ETFs earlier this year.

Smith’s latest attack on the exchange-traded fund sector focuses on three areas.

First, he says, the fact that many ETFs do not contain a basket of the underlying securities or assets which they are attempting to track leads to risks involving counterparty and collateral exposure, particularly when there are asset swap agreements with the bank which is the ETF sponsor. Such arrangements are “of the sort which caused so many problems during the credit crisis”, warns Smith.

Second, says Smith, although the use of ETFs by European retail investors is still limited, asset managers may be using ETFs on behalf of their individual clients, and thereby exposing them to risks that the smaller investor may not understand.

Finally, he argues, in an echo of the warning raised by Bogan Associates late last year, the fact that ETFs can have a short interest equivalent to multiples of the shares in issue represents a real risk.

While ETF defenders have previously argued that high short interest in ETFs is by itself not a concern, since ETF shares can be created to meet any imbalance in supply and demand, this may be easier said than done, Smith warns.

“Take a (US-listed) ETF like IWM,” says Smith, “in which the short interest recently exceeded 100 percent or US$15 billion. IWM invests in the Russell 2000 US small cap index. To invest US$15 billion in the basket of stocks involved would require about a week’s trading—and that is if the ETF creation was the sole trading in those stocks. The scope for a short squeeze is tremendous.”

“The net result,” continues Smith, “is that, across the entire ETF asset class, a portion of the funds which ETF purchasers think have been invested in ETFs, via the creation of new shares, has in effect been lent to hedge funds. The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do.”

“Perhaps these little-understood structural issues explain why 70 percent of the cancelled trades in last May’s Flash Crash were in ETFs when ETFs represent only 11 percent of the securities in issue in the US,” surmises Smith.

  • Luke Handt

    Luke Handt is a seasoned cryptocurrency investor and advisor with over 7 years of experience in the blockchain and digital asset space. His passion for crypto began while studying computer science and economics at Stanford University in the early 2010s.

    Since 2016, Luke has been an active cryptocurrency trader, strategically investing in major coins as well as up-and-coming altcoins. He is knowledgeable about advanced crypto trading strategies, market analysis, and the nuances of blockchain protocols.

    In addition to managing his own crypto portfolio, Luke shares his expertise with others as a crypto writer and analyst for leading finance publications. He enjoys educating retail traders about digital assets and is a sought-after voice at fintech conferences worldwide.

    When he's not glued to price charts or researching promising new projects, Luke enjoys surfing, travel, and fine wine. He currently resides in Newport Beach, California where he continues to follow crypto markets closely and connect with other industry leaders.

error: Alert: Content is protected !!