The increasing amount of investment into exchange-traded funds is a fad, according to firebrand commentator Terry Smith in his latest letter to the holders of the Fundsmith Equity Fund. 

A basic concern is that there is a danger of ETFs being mis-sold, says Smith, who suspects that a lot of retail investors think that ETFs are the same as index funds. This is not the first time he has criticised the fast-growing ETF industry.

“Some of them are, but many aren’t. In particular, the performance of short ETFs and leveraged ETFs may diverge markedly from what an investor who believes they are simply index funds would expect,” said Smith.

“It isn’t hard to give examples in which investors would lose money on a leveraged long ETF if the market went up over a period of significant volatility, or in which they lost money owning a short ETF and the market went down over a period in which there were some sharp rallies,” he continued.

Smith added to what other critics of ETFs have stated, that many ETFs do not actually contain a basket of the underlying securities or assets exactly reflecting the index which they are attempting to track. Instead, some ETFs gain "synthetic" exposure by the use of swaps referenced against a market index.

Although some commentators claim that understanding ETFs is in itself not a problem for retail investors, as it is chiefly institutional investors who use them, Smith said “this of course misses a couple of vital points.” One of these points is that many of those who invest in institutions are themselves retail clients. “Do they really understand the risks their private wealth manager is running with ETFs?” asks Smith.

Aside from the issue of alleged mis-selling, Smith said the hybrid nature of ETF vehicles - in that they combine the features of an open-ended or mutual fund with those of a closed-end fund - gives rise to potential problems.

“They are like open-ended funds insofar as a purchaser buys or redeems so-called creation units. But they are also tradable in the secondary market, so ostensibly providing real time liquidity,” Smith said.

He pointed to the ability to short ETFs, which he said leads to the possibility that a buyer of an ETF share is buying from a short seller and that no new share has yet been created, which conflicts with the fact that “the investors who buy from the short sellers don’t own a claim on the underlying basket of securities or swap in the ETF, they own a promise to deliver the ETF share given by the short-seller".

The main problem caused by this is that as no new shares are created in the ETF, “the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest,” he said. Smith noted how this is a significant problem if reports that there has been short-selling up to levels of 1,000 per cent short in some ETFs, are true.

Exchange-traded funds are more and more becoming a popular component of wealth managers’ portfolios as they offer benefits such as low fees and easy-to-access exposure to particular markets. Smith however, based on the views above and others he outlines in his letter, sees that the potential perils of the ETF market may outweigh the benefits to investors.