Exchange Trade Funds (ETFs), particularly synthetics, are under surveillance by ASIC due to concerns about complexity and counterparty risk.
Synthetic ETFs' use of derivatives, such as swap agreements, had the potential for inexperienced retail investors to be exposed to "increased complexity and counterparty risk", ASIC commissioner Greg Tanzer said.
The products had attracted about $4.3 billion, with 50 to 75 per cent coming from retail investors.
ASIC was working with the International Organisation of Securities Commissions (IOSCO) for standards on these complex retail investment products, with ASIC's concerns "supported by surveillance of current ETF issuers in Australia and discussions with industry participants," he said.
Surveillance visits had been done on the current ETF issuers, Tanzer said, and ASIC would "continue to watch this area closely to help reduce some of the complex regulatory risks that continue to emerge".
One of the corporate regulator's first concerns is the entry of synthetic ETFs into Australia, and the criteria which should be applied to product names, an ASIC report Regulation of exchange traded funds, published yesterday, said.
ASIC said investors should carefully consider the appropriateness of any proposed product using a funded swap mechanism, the report said.
Funded swap structures are considered the most risky, because they involve the transfer of the investor's asset to the counterparty.
ASIC has put the ETF sector on notice regarding 15 proposed IOSCO regulatory principles.
One of the most important principles is that retail investors must be able to clearly differentiate ETFs from other exchange traded products which are similarly named (for example, exchange traded notes, exchange traded commodities) and of which there are 46 products on the AQUA market from three different issuers, the report said.
ASIC's concern is that structured products may have up to 100 per cent swap counterparty exposure and should not be mistaken as an ETF.
Lack of general liquidity and only moderate spreads are also of concern to ASIC.
"Additional issues would arise if the underlying assets of an ETF were illiquid," the report said, "as might occur for certain emerging equity market-referenced ETFs".
In addition, ASIC is concerned that foreign ETFs, offered in Australia, are not regulated overseas in a way that "achieves substantially equivalent outcomes".
While ASIC said retail investors can benefit from simple, low-cost (physical) ETFs, it is concerned that as the market grows that retail investors can distinguish simple ETFs from "riskier and more exotic variations".
Many retail investors are trading ETFs without any financial advice, ASIC has found, including SMSF trustees using retirement funds and this "heightens our interest in ensuring retail investors are confident and informed".
Financial advisers are also on notice that they must give appropriate advice through "reasonable investigation" of the ETF and "reasonable inquiry into the client's personal circumstances" under s945A of the Corporations Act.
Inverse or leveraged ETFs have been proposed but are not issued in Australia, and ASIC is wary of their suitability for retail investors.
"We do not consider that such products should be admitted to trading status on the AQUA market at least until the international regulatory debate is more settled," the report said.
Conflicts of interest are also of concern to ASIC. Some ETFs are based on indices designed specifically for a particular ETF, with the provider being related to the ETF issuer.
This raises the risk that material non-public information may pass between the issuer and the affiliated index provider, with poor tracking performance figures being disguised.
