In this review of ETF due diligence, Frank Spiteri of IFP corporate member ETF Securities, looks at due diligence surrounding Exchange Traded Funds and Exchange Traded Products and asks how planners can best assess the products available.
He says that FCA and European regulators are focusing on the growing 'retail-isation of financial products' - including ETFs and ETFS - prompted by concerns about financial innovation, complexity and appropriateness of financial products.

With this in mind, it's natural for planners to look more closely at product offerings and internal processes but they need to take care to understand and assess risk and reward correctly, he argues.

Mr Spiteri takes a detailed look at the issues surrounding due diligence and provides detailed technical assessment of the criteria which can be used when assessing an ETF or ETP.
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'Retail-isation' of financial products brings ETFs and ETPs into topical focus with regulators as usage grows
The FCA (as well as European regulators) is very much focused on the 'retail-isation of financial products,' an umbrella term for the manner in which financial products are distributed to retail customers. Prompted by concerns about financial innovation, regulators are reviewing the industry approach to complexity and appropriateness of financial products.
A number of retail intermediaries are looking to introduce clients to exchange traded products (ETPs). ETPs have seen tremendous growth since their European debut over a decade ago. To date, ETPs have been primarily used by institutional investors, with retail investors only representing around 20 per cent of the US$350bn of total European AUM. Many analysts expect the retail market share to grow dramatically. In this article I will aim to provide a framework for UK intermediaries, ranging from Financial Planners to execution-only platforms, to better classify exchange traded products and to better analyse their risks.
ETPs: UK Regulatory Framework
In the UK, there are no rules that prohibit the distribution of ETPs to retail customers. Nevertheless, advisers and planners considering services relating to ETPs must ensure that they have the necessary FCA permissions. They must also consider appropriateness requirements and the impact of RDR. Table 1 (right) sets out the current state of play for FCA permissions, appropriateness and RDR as they relate to ETPs. In our opinion, when analysing ETPs, investors should focus on the underlying asset, its risks and its payoffprofileandtheETPstructure. I'lllookateach of these in turn.
A thorough due diligence process will help demonstrate the suitability and appropriateness of an ETP for a client's investment portfolio. Investment vehicles come in a number of forms in the UK, of
which ETPs are one. The selection of an ETP should be considered in comparison to these alternative types of investment vehicle. Understanding and explaining the differences between the investment vehicles will help a Financial Planner to determine which is the most suitable for their client's needs.
Investors often ask how they should calculate the total cost of buying, holding and selling an ETP. The most widely reported cost figure, the total expense ratio (TER), is often incomplete and can neglect a number of internal and external fees and costs, including transaction costs, swap spreads and bid/ask spreads on exchange. It is important for a Financial Planner to demonstrate knowledge of all the components that contribute to an ETP's total cost of ownership, dividing them between internal costs (deducted from the NAV of the ETP) and external costs (incurred when trading the ETP).

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Concepts Defined
1. The Total Cost of Ownership
To help explain the most common components that contribute to an ETP's total ownership cost, we separate internal costs (related to the product) and external costs (incurred in trading the product). Internal costs: Total expense ratio (TER): The total expense ratio is the annual cost of managing the product, expressed as a percentage. The costs included within the TER can vary among providers but usually incorporate: management expense ratio, administrative costs, index license fee and storage costs (for physical ETCs).
Rebalancing costs: The cost incurred by physical ETFs when they buy and sell securities. When the underlying index changes its constituents, the ETF must do likewise. Transaction costs depend on how many and often the index constituents change: the greater the number and frequency, the more expensive the rebalancing costs.
Swap spread: The fee paid by the synthetic ETP provider to the swap counterparties for the swaps agreements. The swap fee is a matter of negotiation between the provider and the counterparty, considering commercial factors such as the cost of the counterparty hedging its swap exposure, the cost of collateral, its credit rating and its own profit margin. Generally, more illiquid or exotic exposures have more expensive swap spreads. Sometimes the swap spread is incorporated into the TER of ETPs.
External Costs: Bid/ask spread: As with trading any asset on-exchange, there is a spread of prices at which an ETP can be bought or sold.
Brokerage fee: Cost paid by the investor to a broker to buy or sell an ETP.
Tax: Different ETPs will incur different taxes, depending on the product itself, the jurisdiction it is domiciled in and the circumstances of the investor. Investors are wise to contact tax experts in their jurisdiction to clarify any charges.
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2. 'Contango/backwardation.'
ETCs tracking non-metal commodities usually track futures indices. Unlike futures, which expire, futures indices are constructed to simulate a continuous exposure to a commodity future of a particular maturity. To maintain a futures position at a certain point on the futures curve for a particular commodity, it is necessary to replace the contracts in a process known as 'rolling.' A futures position is rolled when contracts are sold prior to their expiry date and new contracts with a later delivery date are purchased. The futures market is in 'contango' when the price of the contracts being purchased is more than the price of the contracts being sold. This would represent a cost to investors. The opposite of contango is known as backwardation: when the current futures contract can be sold for a higher price than it costs to buy the new futures contract.
3. Arbitrage Mechanism:
Arbitrage is the purchase and sale of an asset to exploit a price difference. Imagine a physical FTSE 100 ETP trades for £20 and the underlying assets that constitute the ETP are worth £25. The Authorised Participant in the primary market can buy the ETP on exchange and redeem it for the underlying shares. By selling them, the AP makes a profit of £5. As it buys the ETP and sells the underlying assets, it reduces the price difference between them. Eventually, the prices converge and the arbitrage will no longer be profitable. Through this process, the Authorised Participant has returned the ETP to its NAV.