13th June 2012 by Martin Bamford

Some new research from Legal & General Investments has found that seven in ten financial advisers are concerned about the counterparty risks associated with derivative based index funds and Exchange Traded Funds (ETFs).

The research found that 40% of advisers were were very concerned about counterparty risks, with an additional 29% expressing that they were slightly concerned.

In addition, six in ten advisers expressed concern over the counterparty risks associated with stock lending programs.

Using index funds and ETFs can be a very cost efficient way of accessing various investment markets. Their very low fund management costs combined with a close replication of the underlying index or asset class often appeals to investors.

Some advisers have become evangelical over the benefits of passive rather than active investing while others, including Informed Choice, can see the merits in both fund management approaches.

When assessing the features of index funds and ETFs, it is important to consider counterparty risks carefully.

Those index funds and ETFs with synthetic replication use derivatives and other financial instruments with the aim of more closely tracking the underlying index. This reduced tracking error comes with a cost; the introduction of counterparty risk where a third-party agrees to cover the difference between the returns from the fund and the returns from the index.

Our preference is always to select and recommend funds which do not introduce this counterparty risk to portfolios.

The use of full physical replication means the ETF actually holds stocks from the underlying index and therefore avoids introducing counterparty risk for the investor.

Our aversion to counterparty risk extends also to the use of structured products, which aim to combined capital protection with equity market returns. Whilst we will always consider these products when making our recommendations, we are unlikely to recommend them unless it is possible to fully quantify the additional risks involved.

Structured products which simply swap capital risk for counterparty risk can often mislead investors into believing they are onto a sure thing. The same risks happening with some styles of index funds and ETFs which use synthetic replication to deliver more accurate returns.

Photo credit: Flickr/lac-bac