I was horrified to read that an active fund manager, Charles Plowden, has compared Exchange Traded Funds (ETF) to Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS). This is misleading and simply incorrect as are many of the other criticisms which he made at a conference in Edinburgh. Here are some of his comments:

• "ETFs account for about 30 per cent of the money in the US market, and they are created, it seems to me, by investment bankers so they can have a product to sell."
• "Just like before the financial crisis when mortgage products and CDOs were created by investment banks, and sold to people, those buyers didn’t know what they were investing in, didn’t care what they were investing in. It is the same with a lot of the ETF money now, it is dumb money."
• "...it is like every investor is wearing a blindfold. They don’t know what they have invested in. It is fine when everyone wearing the blindfold is moving forward, but as soon as one trips up, everyone falls down."

So what are all these confusing three-letter acronyms and why do they matter to you as an investor?

What is an Exchange Traded Fund?

Let's start with Exchange Traded Funds. These are pools of money invested to track the value of baskets of assets. The basket can be anything: shares, bonds, commodities, property... The most popular use of ETFs is to track stock market indices, and the largest and oldest fund is called Spyder, it's an ETF that tracks the US S&P 500 index and its pot of money (Assets Under Management, another three-letter acronym) is $252 billion at the time of writing. See the latest list of the largest ETFs here: http://etfdb.com/compare/market-cap/.

You buy an ETF just as if you were buying a stock, this is because ETFs are, as their name suggests, traded on a stock exchange. The prices of ETFs are low, so they are within reach of almost any investor and they have created access to previously inaccessible markets. Now anyone can buy a tiny slice of baskets of US corporate bonds and government bonds, emerging market stocks and bonds, commodities and even styles of investment such as "value" or "momentum".

Of course active fund managers would criticise passive ETFs because investors are moving money out of their, mostly underperforming and relatively expensive, active funds and into passive funds. Click on this picture to see our interview with S&P Dow Jones' Andrew Innes if you want to see the abysmal performance of active managers for yourself:

People Do Know What They're Investing In

Charles Plowden's primary complaint is that ETFs are opaque packages of financial instruments and that investors buy them blindly without looking inside the box. If this were true it would be awful, but it's not. Brokers, ETF creators and regulators are falling over themselves trying to explain what's in every ETF. ETF providers have to produce what's called a Key Investor Information Document (KIID), a 2-page fact sheet explaining the risks of the ETF simply and concisely.

Okay, I'm a finance nerd, but I'd go as far as to say some KIID documents are beautiful. I'm not kiiding you, take a look at this example for the largest ETF in the World, the ultra-cheap, ultra-large Spyder fund (ticker SPY). Can you find a) the investment objective, b) what the fund contains and c) the risks of owning the fund?

CDOs and CDS are nothing like ETFs

Here are some metaphors that spring to mind when comparing Exchange Traded Funds and Credit Default Swaps and Collateralized Debt Obligations:

• F35 fighter jet versus Ryanair Boeing 737
• Bugatti Chiron versus Ford Focus
• Buckingham Palace versus a terraced house in Merthyr Tydfil
• A bespoke Savile Row suit versus an off-the-shelf suit from Moss Bros

Anyone with a hundred quid to spare could buy an exchange traded fund, whereas only an institutional investor with millions to invest, such as a hedge fund, an insurance company, a pension fund or an ultra-high net worth sophisticated investor could buy credit derivatives like CDS and CDOs. As the metaphors should make clear credit derivatives aren't available to "normal" investors.

The second major difference is that CDS and a lot of CDOs have leverage. If you buy a share or a bond you pay the price up front, then your investment gains or loses value as its price changes. A CDO or CDS doesn't require full payment up front but exposes you to price changes based on the notional value of your CDO or CDS contract. The notional value can be millions but the money paid up front can be a fraction of that amount. This is leverage and  it is dangerous because you can lose much more than you invest initially. This is also why spread betting is very risky, as it also has this leverage or amplification of returns which can burn you badly if the market turns against you. Click on the image to see how Chris Stringman lost thousands thanks to leveraged spread bets. The vast majority of ETFs do not have leverage, and be wary of those that do: you'll see 2x (two times) or 3x in their name.

The third big difference between ETFs and CDS and CDOs is that CDS/CDOs are derivatives. Derivatives "derive" their value from the price of other assets and this relationship is not one-for-one. If you buy a derivative like a call option on the S&P 500 and the S&P 500 goes down by 10% your derivative will go down by less than 10%, which is the whole point of a call option. They payoff is said to be non-linear. This is exciting and potentially dangerous. ETFs move in step with their index, so if the S&P 500 moves down by 10% so will your S&P 500 ETF tracker's price. Trading floors reflect this difference, so that the "delta one" desk which trades ETFs is totally separate from the options desk which trades derivatives. If you're interested in finding out more about derivatives then my book deals with them in detail, or book a power hour to talk about options:

ETFs Are Not Dumb Money

One of the most arrogant and offensive statements by Charles Plowden is that investors in ETFs are "dumb". Let's take a look at the primary owners of SPY as an example. In the US there's a regulatory requirement to state the largest owners of a stock traded on an exchange known as 13F. Take a look at the ownership of SPY and you may be in for a surprise: 69% is owned by institutional investors (investment banks, pension funds, insurance companies, hedge funds...) who are (supposedly) "smart money". Click on this image to see the latest ownership breakdown of SPY on Nasdaq's website.

This high level of institutional ownership of an ETF is not unusual. The next largest ETF, iShares Core S&P 500 ETF (ticker IVV), has 57% institutional ownership, Vanguard's Total Stock Market ETF (VTI) is 31%, iShares MSCI EAFE fund which tracks developed market stocks excluding the US and Canada (EFA) is 73%... Of course investment banks are market makers for ETFs so have to hold some inventory in order to trade the funds, just as a supermarket holds inventory to stock its shelves. Fund managers use ETFs too. Actively managed funds which are multi-asset, incorporating a mixture of stocks, bonds, commodities and real estate often use ETFs as a cheap and efficient way to build their portfolios. Vanguard's LifeStrategy funds use their own ETFs for example. The fact that professional asset managers buy and therefore trust ETFs shows that they are not the demesne of investing neophytes as Charles Plowden suggests.

ETFs Will Not Amplify Selloffs

Plowden, and others, think that ETFs are a destabilising force during market selloffs. The logic runs as follows:

1. Something triggers a small market correction (a 10% fall from the previous peak)
2. "Dumb" retail ETF investors sell their holdings because ETFs are highly liquid (cheap, easy & fast to buy or sell).
3. Price falls in large companies, which dominate the largest share ETFs, will be amplified.

However, the fact that institutional investors hold a large part of the ETF universe suggests that a lot of money in ETFs is "sticky". If there's a market selloff institutional investors are less likely than retail investors to panic and sell their holdings. And so ETFs are unlikely to be a destabilising force during such a selloff given their current size and the pattern of ownership.

The danger is unlikely to lie in the share market, which is very liquid. The danger lies in markets where the underlying basket of assets is illiquid, or slow to sell. This would be the real estate market, the corporate bond market, particularly for high yield credit (aka junk bonds) or emerging market bonds. All three of these ETF categories have grown rapidly as investors have reached for yield during this period of ultra-low interest rates. After the UK referendum, for example, property funds sold off heavily but the fund managers could not sell property as quickly as investors were selling their fund. This created a downward spiral in prices in line with warnings from the Bank of England.

ETFs Are Useful But Aren't Perfect

As with any financial investment ETFs have their own bundle of risks. In fact, we've created our own list of five dangers in ETF investment (with a video!). These include hidden costs, mortality of ETFs, currency risks, liquidity risks, and leveraged ETF risks.

• ETF Flaws

The fact that we're getting increasingly shrill complaints about ETFs from active managers is a sure sign that they sense a change in paradigm. As faith in active managers is crushed by overwhelming evidence of their underperformance leaders of this Alpha Cult will issue more rallying cries. But as more people weigh the evidence and vote for passive these cries will echo unheard through the empty marble corridors of Mayfair.