Exchange-traded funds, or ETFs, constitute a portfolio construction tool that is much prized by investors, since these instruments are at the same time liquid, flexible and cost-effective.

This universe has seen massive growth since the appearance of the first ETF in 1993 in the form of the SPDR S&P 500. However, ETFs were only introduced in the GCC region earlier this year. Saudi Arabia's second ETF was launched last month bringing the total number of ETFs currently available in the GCC to three.

In recent years there have been considerable advances in how ETFs are constructed, especially since the introduction of what is known as the synthetic replication method (which uses derivative instruments), as opposed to physical replication (purchase of all or some of the underlying components). These advances have generated the appearance of new risks, similar to those associated with certain structured products. We therefore consider it important to review the main risks presented by these instruments.

The first concerns their ability to replicate the performance of the asset they are intended to represent. Observation shows that, over the long term, the performance of different ETFs intended to represent the same asset can vary substantially depending on how they are constructed. This risk has grown recently with the introduction of new ETFs aimed at replicating asset classes that are exotic, have low liquidity, or offer short or leveraged exposure.

Here, for example, we could mention ETFs that seek to deliver the inverse of the performance of the underlying, with or without leverage. The fact that the replication is based on daily performance and the use of derivative products may well lead to significant performance differences compared with the underlying. This is particularly true in the case of leveraged ETFs — which offer a multiple of the daily performance of an asset — simply because of the cumulative effect of repeatedly multiplying the daily performance over a given period.

The second main risk factor concerns counterparties. The use of swap instruments (contracts to exchange a stream of cash flows with a financial institution) has ballooned in recent years, especially in Europe, where ETFs based on this replication method now account for three-quarters of the market.

However, these contracts generate a counterparty risk with regard to the institution issuing them. Of course, reasonably effective protection measures have been put in place by ETF issuers, particularly since European legislation (UCITS) requires collateral worth 90 per cent of the value of the ETF to be pledged. This implies that if the counterparty should default, the risk of loss to the investor will not in theory exceed 10 per cent of the value of the ETF.

Establishing the equivalence between the collateral pledged and the underlying which the ETF aims to replicate can nevertheless present a very real problem.

Illiquid strategies

Finally, some ETFs that have appeared recently are based on relatively illiquid strategies such as hedge funds or private equity. Attempting to replicate such strategies using an ETF involves trying to create artificial liquidity, which is not possible in our experience.

ETFs, however, offer efficient access to a multitude of sectors, themes and investment styles. They provide instant exposure to an underlying trend, and allow investors to withdraw again just as rapidly. They are particularly suited to portfolio construction using the core/satellite approach, and can also offer an alternative to certain derivative strategies.

The writer is Head of Quantitative and Fund Investments, Pictet & Cie.