Exchange-traded fund (ETF) investment does not come without risks and the products are increasingly attracting regulatory scrutiny, according to the Reserve Bank of Australia (RBA).
"The ETF industry has grown strongly in a relatively short period of time, with the industry attracting greater attention as it grows in size," RBA analysts Mitch Kosev and Thomas Williams said in a report.
"The original appeal to investors of these products was their simplicity, low-cost diversification benefits and ability to trade intraday."
"While this is still broadly the case, the evolution of the industry has resulted in a greater variety of ETFs becoming available to investors and improved accessibility to different asset classes."
The central bank said ETFs had become more complex in the structure and types of strategies they employed in generating returns, including synthetic replication and inverse leverage, which had created new opportunities and challenges for investors, market participants and regulators.
"Generally, concerns about ETFs stemmed from liquidity and counterparty risk and, in some cases, complexity and a lack of transparency," the report said.
"An ETF's liquidity on the primary market is linked to the liquidity of the underlying assets. In addition, some ETFs may not trade actively intraday and market volatility can inhibit liquidity for ETFs if large ETF traders withdraw from the market or there is difficulty in creating new ETF shares."
Events such as the 'flash crash' of the S&P 500 on 6 May 2010, where ETFs were severely affected by the sudden fall in American equity prices, had also raised questions as to their potential contribution to heightened market volatility as well as their broader impact on market structure, it said.
"There has also been a shift by some ETF providers towards a swap structure where collateral is pledged to the fund," it said.
"However, this may not guarantee immediate access to the collateral in the event of a counterparty default and highlights the importance of sound collateral management practices."
