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Systemic risk unease puts exotic ETFs in regulators’ sights

Regulatory criticism of synthetic and levered ETFs might force asset managers out of these products altogether. The bigger risk is that it tarnishes the entire trillion-dollar ETF industry. Louise Bowman reports.

WHEN UK INVESTMENT manager Evercore Pan-Asset announced at the end of June that it planned to remove synthetic exchange traded funds from most of its portfolios it seemed that the lingering disquiet in this part of the ETF market might be about to come to a head. Having enjoyed rampant growth over the past decade, the ETF market found itself the target of an IMF Financial Stability Board paper published in April that raised concerns about the risk that these supposedly vanilla instruments embody. While asset managers have debated the merits of the FSB’s position, the news that they might now start pulling out of these instruments has big implications for the market.

Regulatory concern has been prompted by the growth in synthetic ETFs which now account for 45% of the ETF market in Europe, according to the FSB.

Unlike physical ETFs these instruments enter into an over-the-counter derivative with a counterparty rather than replicating the index physically. It is this – and the growth in levered ETFs – that is causing concern. "The drift of ETFs away from their original bearings is striking," said Bank of England deputy governor Paul Tucker in a speech in London in July.

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