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Amid the heated war of words over the structural risks of ETFs, a new fund offers investors the chance to compare the synthetic and physical replication approaches in what has traditionally been one of the more difficult areas of the market for tracker funds to access.

HSBC this week launched the first ETF in Western Europe to offer physical tracking of Russian equities (Russian brokerage Troika Dialog issued an ETF investing in domestic shares last year).

HSBC’s sales pitch alluded to risks in competing synthetic ETFs. “By putting together a physical Russian equity ETF, we are responding to investors’ concerns with respect to complex ETFs and demonstrating our commitment to delivering products that are as transparent and simple as possible,” said Farley Thomas, the bank’s head of ETFs.

So why isn’t the ETF market’s foremost exponent of physical replication—iShares—competing with HSBC in what might seem its natural habitat?

iShares did launch an ETF tracking exactly the same index as HSBC’s new fund—the MSCI Russia capped—last September. But it chose to use swaps to achieve its objective, rather than buying the underlying index shares. Credit Suisse also opted for the synthetic route last August when it launched a new range of emerging markets trackers.

“iShares has always recognised the value of swap-based structures in providing access to markets where the assets are either difficult to hold in a physical form or where UCITS III compliance may be difficult due to index-related issues,” the ETF market’s largest issuer states on its European website.

When I met with the firm’s head of product strategy, Feargal Dempsey, yesterday, he was at pains to clarify that iShares did not want to be seen as rejecting synthetic replication as a tracking methodology. iShares is considering further fund launches of this type in Europe, he said.

It’s worth remembering that the highly publicised tracking problems experienced in 2009 by iShares’ flagship US-listed MSCI Emerging Markets ETF, EEM, which uses physical tracking, were due in significant measure to Russia and to the highly divergent performance of domestic—Russia-listed—and “offshore” (ADR and GDR) versions of Russian shares in the MSCI index.

The global depositary receipt (GDR) of Russia’s main savings bank, Sberbank, for example, traded at a 130 percent premium to the Russia-listed version of the bank’s shares early in 2009. The premium fell to zero by the end of the year, severely affecting the performance of those funds (like EEM) that held GDRs rather than the domestic shares used in the index calculation.

For its part, HSBC is well positioned to pursue the physical replication route in emerging markets due to the bank’s extensive global network of sub-custodians (although in Russia, it is outsourcing this role to ING). For other issuers of ETFs tracking Russian share indices, it’s obviously still preferable to outsource the problem of replication to those investment banks that specialise in Russian share trading. Outsourcing the index replication via swaps means that a problem such as that created by Sberbank in 2009 becomes one for the swap counterparty, rather than for the ETF issuer.

All these considerations go to show how nuanced the debate is when it comes to competing ETF methodologies. It certainly won’t be easy for regulators to draw a dividing line if they are really considering restricting access to certain types of funds.

And while Russia may stand out as a test case for the synthetic/physical debate, investors shouldn’t lose sight of the fact that there are weightier risks to face when they consider sending their hard-earned cash eastwards.

“The concept of fiduciary duty on the part of a company’s management is generally non-existent. Local laws and regulations may not prohibit or restrict a company’s management from materially changing the company’s structure without shareholder consent. Foreign investors cannot be guaranteed redress in a court of law for breach of local laws, regulations or contracts. Regulations governing securities investment may not exist or may be applied in an arbitrary and inconsistent manner,” says the prospectus for the HSBC MSCI Russia Capped ETF.

As far as Greece is concerned, it’s now merely a matter of when a default occurs and by how much bondholders’ hair will be cut.

John Hussman’s latest weekly market commentary gives us a chart that links three variables, derived from current Greek bond yields: the likelihood of default, expressed as a percentage; the time from now to the default event; and the recovery rate (a 95 percent recovery rate equates to a 5 percent “haircut”, 60 percent recovery is the same as a 40 percent haircut, and so on.)

What investors are collectively telling us, Hussman’s chart makes clear, is that default is almost certain, and it's only a matter of by how much and when. Whether you assume that 5 percent, 20 percent or 40 percent is taken off the net present value of Greek government debt, a default by 2013 is priced in completely. Even a massive 95 percent wipe-out of Greek debt value is given as having a four in five chance in ten years’ time.

But, though Greece is important, it’s a sideshow when compared with the battle over potential writedowns in the debt of European banks.

According to Morgan Kelly, writing in May in the Irish Times, late last year during bailout negotiations Ireland’s government had reached a notional agreement with the IMF to impose losses of up to two thirds on holders of senior debt in the country’s banks. Remember that it was Ireland’s decision in September 2008 to backstop bank obligations that eventually led to an unsustainable burden for taxpayers. The country’s politicians realised by 2010 that they had made a mistake (to their credit, one might think), and sought to reverse the policy.

However, the proposal to impose “haircuts” on holders of those senior Irish bank bonds was vetoed from an unexpected direction—by US Treasury Secretary Tim Geithner, according to Kelly. Geithner’s position of refusing to contemplate losses for senior debt holders was apparently shared by the European Central Bank.

One cause of policymakers’ hypersensitivity over the idea of senior debt holders actually bearing the risks they signed up for is the prospect of renewed bank runs. In many countries senior bank debt ranks pari passu (equally) with bank deposits, meaning that if bondholders face losses, so do depositors. And since the financial crisis, with the single exception of Iceland, the notion of allowing Europe's bank depositors to take a hit when an institution fails has been excluded from polite debate.

But things may be changing. Irish officials have in the last week again flagged the prospect of imposing losses on senior bondholders, causing the ECB to issue an immediate slapdown. While the ECB’s response indicates that such a policy remains taboo at EU level, a precedent has in fact been set in February (in Denmark) for burdensharing to be imposed on owners of senior debt, as Tracy Alloway of FT Alphaville covered at the time.

And, in a little-publicised case, British financial authorities last week announced that a small bank (with an unfortunate name, given financial history, “Southsea”) would enter insolvency proceedings, but that depositors in the bank would be protected only up to the £85,000 limit for the UK’s deposit insurance scheme. If you had more than that in the failed bank—and some individuals did—then you’ll have to enter your claim in court as a creditor, and face the prospect of receiving only pennies in the pound on the amount you’d deposited in the bank over and above the insured limit.

Compare the way the authorities have treated Southsea with the blanket bailout of all depositors in Northern Rock (and in the UK branches and subsidiaries of failed Icelandic banks) only three years ago, and you’ll sense that a tectonic shift may be taking place, at least at the individual country level in Europe.

So far, broad measures of European banking sector credit risk, such as the Markit iTraxx Europe Senior and Subordinated financials indices (which measure an average of 25 credit default swap spreads on the senior and subordinated debt, respectively, of European financial institutions) are registering concern, rather than panic. See the chart below.

Complicating things further (when you look the CDS market) are attempts by some overindebted issuers to try and restructure obligations in ways that avoid “triggering” default clauses in related credit derivatives. According to Tamara Burnell of fund manager M&G, this has also now become a political issue (and an international one), given potential cross-border exposures and risks of contagion.

Playing with fire is a mild way of describing such attempts to wriggle out of CDS-related obligations, since the potential gains for some institutions if payouts can be avoided are likely to be overwhelmed by a much bigger market shock if investors worldwide find that the contracts they had bought to hedge bond risks turn out to be unenforceable.

These CDS-specific caveats aside, it’s not Greece that investors should now be focusing their attention on. For equity investors as well as for the fixed income markets, how the stand-off over bank debt burdensharing is resolved seems the most crucial question of all.

Vanguard’s investment boss, Gus Sauter, told the audience at an event held by the firm in London last week that capitalisation-weighted indices represent “the market portfolio”.

William Sharpe’s 1964 Capital Asset Pricing Model (CAPM) provides the basis for Sauter’s assertion. Under CAPM, which you’ll be taught in any business school, a portfolio in which each stock is held in the same proportions as it is in the wider market should be considered optimal.

It’s no coincidence that index funds—which are the foundation of Vanguard’s US$1.8 trillion asset management business—started to become popular at around the same time as CAPM established itself as the leading financial theory.

And capitalisation-weighting still provides the basis for the portfolio holdings of the vast majority of passive funds, as measured by the assets allocated to them. Beyond the index and exchange-traded fund market, cap-weighted indices are also used as benchmarks by most active funds.

In the last ten years, however, CAPM has come under sustained attack. Some (less serious) criticisms relate to the model’s unrealistic assumptions: that trading is frictionless, that short-selling is possible at no cost, and that you can borrow without limit, for example.

But other, weightier assaults on CAPM dismiss its central tenets as essentially worthless.

James Montier (at the time a strategist at Société Générale, now an asset allocator at fund manager GMO) argued in early 2007 that CAPM’s categorisation of stocks into low and high beta (stocks with lower and higher sensitivity to moves in the overall market, in other words) doesn’t work. Over time, said Montier, low-beta stocks actually outperformed high-beta stocks in a rising market; the opposite of what you should expect.

And—anticipating a criticism often levelled at proponents of alternative weighting methodologies by defenders of CAPM—it’s not just a question of a “value tilt” causing the unexplained performance divergence. In fact, said Montier, even within the growth category of the market (with “growth” stocks defined as those with a low book value/price ratio) you find that low beta stocks have historically outperformed those with high beta.

An attack from a different angle is offered by those who focus on CAPM’s (and finance theory’s) inaccurate measure of risk. CAPM is based on a mean-variance framework, which defines the distribution of stock returns over time as a bell curve, implying that risk (measured as standard deviation from the mean) can be measured precisely and predictably.

Nothing could be further from the truth, argued Benoît Mandelbrot in a 2005 book with a tongue-in-cheek title, The (Mis)behaviour of Markets. Those damn markets (those messy human beings acting in aggregate, in other words) keep refusing to fit into our nice mathematical models, said Mandelbrot, going on to show conclusively that the actual behaviour of stocks is far wilder than classical finance theory presupposes.

At our recent Inside ETFs Europe conference in Amsterdam you could hear this debate being re-enacted in person. Indexing should be based on the (CAPM-inspired) market portfolio, said Paul Kaplan, chief investment officer at Morningstar. Any other methodologies represent an active bet against the market and should be recognised as such, Kaplan went on. Not so, said Denis Panel, CIO of BNP Paribas Investment Partners; cap-weighted indices are only efficient under a CAPM framework, whereas in reality this model doesn’t work. Alternative approaches to risk-based indexation are the future for the passive funds business, said Panel.

It’s worth remembering that there are also business reasons for the differences in index approach. By virtue of its sheer size, you’d expect Vanguard to stick to cap-weighting, since any other strategy would cause the firm immediate liquidity and capacity problems when managing portfolios. By contrast, smaller market participants have every incentive to try innovative index methods to gain market share.

But who’s right? In my opinion, treating any index methodology as a neutral starting point is a value judgment that risks being misleading. Just as you wouldn’t suggest that any stock portfolio was intrinsically “right”—you’d expect to judge it later on its performance, risk, and relative to competitors—neither should you do so when it comes to an index.

Perhaps we’re all just indulging in “index semantics”, in the words of Rob Arnott. But for some reason we don’t seem to tire of hearing the arguments pro and con, however often they are replayed.

We may still be short of a full comparative study of index methodologies, involving not only obvious things like security selection and concentration, risk and return, but also less widely followed metrics like index premia, tax efficiency and rebalancing costs. One thing’s for sure, though—the index debate is leading to an increasing variety of choice. And that must be a good thing for investors.

Why? First, the quantitative easing (QE) tailwind that has propped up bond prices since early 2009 is beginning to wane.

The US Federal Reserve’s QE2 programme is forecast to end later this month. Few doubt that the Fed, if pushed (and despite current denials), could launch a round of QE3 to counter future economic weakness. On the other hand, the effects of the current round of easing have proved highly contentious.

I pointed out in a blog back in February that the huge spike in commodity prices that we’ve seen over the last year could be traced back almost to the day that Fed chairman Ben Bernanke announced QE2. Although the US government has denied a causal link between its bond purchases and soaring raw materials prices, the undeniable fact is that the last few months have seen geopolitical upheavals of a scale that should make any policymaker think twice before repeating the medicine.

The second reason for caution in bonds is the deepening eurozone crisis. The FT reminded us yesterday that trading volumes in the bond markets of the European periphery have fallen to record lows, even as yields have risen to multi-year highs.

This paralysis is a sure sign that investors are now resigned to the prospect of defaults and are avoiding placing trades in size until the axe has dropped and bonds’ new terms are worked out. And while the FT article suggests that Italian and Spanish bonds so far seem immune from this trend, continuing to trade with healthy volumes, it’s surely too early to sound an all-clear for these markets. After all, deteriorating liquidity in the least creditworthy segments of the structured finance market in 2007 was a sign that problems were about to become much more widespread.

The intertwining of government and bank liabilities—with European banks propped up both by their own governments and by the European Central Bank—is also a reason why default risks could easily spread, and dangerously so.

The final reason for caution is ETF-specific, but is also a direct result of central bankers’ zero interest rate policies and other stimulus measures such as QE. And that’s the sheer volume of investors that have been driven into riskier, yield-seeking areas of the bond markets in an attempt to preserve purchasing power.

While the recent trend for some high-quality corporate bond yields to trade below the yields of equivalent-maturity sovereign paper makes sense, there’s plenty of money that’s flowed into less secure, higher-yielding paper, and via ETFs. And particularly in the US ETF market, I might add.

Deutsche Bank’s ETF strategist, Christos Costandinides, reminded us in a research report released last week that several corporate bond ETFs suffered badly during the 2008 crisis, with some registering discounts to NAV of 5 percent or more. The problems associated with pricing bonds and bond indices (and the ETFs that follow them) haven’t gone away, says Costandinides, and the make-up of those indices is often not as transparent as it should be.

All of these concerns suggest that the bond ETF boom that’s been a feature of the last couple of years may be passing its peak. And with bonds dwarfing equities by some margin in their overall market footprint, that’s a reason for all of us to watch out.

Global ETF assets are approaching US$1.5 trillion, well on the way to Debbie Fuhr’s long-standing target of US$2 trillion. But there must be a gnawing concern amongst exchange-traded fund providers that the going is getting tougher, given the deluge of negative press coverage that’s come their way in recent weeks and months.

Even the UK’s middle market, mass-circulation tabloid, the Daily Mail, has taken a break from its usual diet of celebrity gossip and immigration scares to run an ETF risk story (“Alluring but dangerous..the truth about ETFs”). Things are clearly getting serious. Could this be the high point of the ETF industry’s growth trend?

Strangely enough, the recent risk warnings in the press may not be as bad for ETFs as it might seem.

I’m reliably informed that the largest-ever audience feedback figures for the BBC’s Money Box consumer finance radio programme, which has been running since the 1970s, came when the programme’s then-presenter, Alison Mitchell, ran a piece in the mid-1990s about the dangers of the ostrich farming craze.

Remember that one? “You can have the financial benefits of farming without having to put your wellies on," said one former British television newsreader, lured into promoting ostriches as an investment. "What are you going to do? Stick your head in the sand and wait until it goes away?” ran her sales pitch.

Another ostrich promoter latched onto the risks of mad cow disease, predicting that we’d all be eating bird rather than beef in the future.

Ostrich farming did turn out to be a scam, after all, of course. Here’s one of the stories of the time.

But what did the BBC find when it warned the general public that schemes sold as “Ostrich-Nest Egg” might not be all they appeared?

Listeners dialled in not to ask how to report their nearest ponzi scheme operator to the financial authorities, but overwhelmingly to find out how they could get a piece of the action!

I should clarify at this point that I don’t think investing in ETFs resembles buying a share in a South Wales bird farm. And, as I wrote last week, in my opinion the risk comparisons between ETFs and CDOs have been over-egged (sorry).

But given that the worthy debates over short-selling, securities lending and collateral risks in ETFs are still going to be going on in a few months’ time, and probably next year too and the year after, perhaps it’s time for exchange-traded fund issuers to start preparing for a summer break.

After all, if ostrich mania is anything to go by, they may find that their funds have attracted plenty of new investors by the time they return in the autumn.