Ask MoneySense: ETF dangers

By MoneySense Staff on April 17, 2012
Estimated reading time: 1 minute

Do Canadian ETFs use derivatives and does this make them vulnerable?

I have read about the dangers of investing in exchange-traded funds. Apparently European ETFs often use derivatives, and this can make them vulnerable. Does the same apply to Canadian ETFs?

—Ian Simons, Killarney, Man.

In general, no. Most Canadian and U.S. ETFs (though not all of them) invest directly in stocks and bonds. An ETF based on the S&P/TSX Composite Index, for example, will hold all of the stocks that make up that index. It’s different in Europe. “Many European ETFs are ‘synthetic,’ meaning they get their exposure from a total return swap rather than actually holding the underlying securities,” says Al Kellett, an analyst with Morningstar. Swaps are complex derivatives that involve a third party (called a counterparty) who holds the stocks or bonds in the index and promises to deliver their return. This arrangement can reduce costs and taxes, Kellett says, but it also introduces the risk that the counterparty will default. And in Europe, the counterparties are often banks embroiled in the continent’s debt crisis. Canadian ETFs pose fewer risks, but ultimately, if a banking crisis occurs in Europe, it won’t matter whether your money is in ETFs, mutual funds, or individual stocks. We would all get dragged down.

Email your questions to [email protected]