The founder of the eponymous Fundsmith investment house set the industry buzzing last year by attacking much of the ETF industry, claiming that synthetic, swaps-based products contained exactly the kind of counterparty risk hazards that had come to light in the credit crunch. Smith has also hit out at leveraged “long” and "short" ETFs. (Synthetic ETFs take their name from how they do not hold an underlying basket of physical securities, but replicate returns from an index via swaps and other financial instruments.)

“I am sure as I can ever be that they are being mis-sold,” Smith told journalists in a briefing at his London offices yesterday.

“There are clearly risks involved in ETFs of the sort people have experienced in the financial services industry in the last three to four years,” Smith said.

Smith's warnings appear to have been heeded by regulators. Last July, the Financial Services Authority said it was concerned about aspects of the exchange-traded products sector and was investigating for potential problems. 

“One more problem with ETFs became apparent to me in the course of this debate. ETFs are represented as low-cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks. This seems counterintuitive: how does a low-cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to 'clip the ticket' of the ETF,” he said.

Smith went on to argue that people are right to argue that an index fund is “often the investment you make in the equity markets. But if you decide this is correct, buy precisely that, an index fund, not an ETF”.

His views have stirred up criticism. For example, Alan Miller, founding partner and fund manager at UK-based wealth manager SCM, told this publication last June that ETFs can be used, at low cost, by managers in building a portfolio that suits clients' risk and reward requirements.

But Smith is unrepentant. He says research shows that ETFs are touted as easy to trade on exchanges, but that high trading turnover will blunt returns by increasing trading costs. “So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots.”

Pets and chocolate

The firm’s sole fund, its Fundsmith Equity Fund, which opened on 1 November 2010, has risen 15 per cent since inception, up 8.4 per cent in 2011, compared with 3.2 per cent and -4.5 per cent by the MSCI World (sterling) index for those periods, respectively.

At yesterday’s briefing, Smith and his colleagues argued that family offices, high net worth individuals and private banks are among the clients interested and investing in this fund. “One of the things that appeals to them over the very long term,” he said.

A pessimist about the outlook for the global economy, including China, Smith favours “defensive”, cash-generative firms supplying staple goods and everyday “luxuries”, citing the examples of firms that build elevators, produce and sell chocolate, coffee, household cleaning materials and pet food. Pet food, in fact, is Smith’s all-time favourite industry.

In the case of Swiss food and drinks heavyweight Nestlé, Smith said the firm has obvious attractions in terms of its risk profile and earning power. It currently has a dividend yield of around 4 per cent – about double the amount to be earned on US Treasuries – and yet credit default swaps prices show the price of insuring the Swiss firm is lower than for developed countries’ sovereign debt, he said.

Explaining his gloomy macro-economic prognosis, Smith said it was unlikely that the problems of the eurozone, for example, can be solved by even higher spending and more debt; he also argued that there is a risk of a "hard landing" in China and cast doubt on the reliability of China's economic data.