Rarely a week passes without yet another exchange-traded fund hitting the market, highlighting how vibrant this segment of the investment world now is. But one luminary in the London financial industry has fired a warning that some ETFs carry considerable risks.

Terry Smith, who late last year set up the investment house Fundsmith, said in an article on his own webblog that the $1.181 trillion ETF industry contained certain dangers. While many ETFs were and are marketed as purely index-tracking products, not all such products were as “inactive” as they might first appear, Smith wrote.

“I suspect that the average investor regards all ETFs as just another form of index fund, and indeed many of them are. But many aren’t and therein lies the potential for misunderstanding. Or worse,” writes Smith. He argued that in some cases, there is even the risk of a “mis-selling scandal” with some products.

He continued: “Some ETFs do indeed replicate the performance of an index by purchasing a weighted package of all or most of its constituent securities. But many so-called synthetic ETFs do not do so and instead use so-called swap agreements with counterparties who agree to provide a monetary return which matches the underlying asset class or the index the ETF is seeking to track. Anyone who has studied the events of the credit crisis should be able to spot a potential problem here: what if the counterparty supplying the swaps defaults? This risk may once have been considered theoretical, but after the collapse of Lehman and the need to rescue AIG in order to prevent the contagion from a default it surely no longer is.”

Exchange-traded products have expanded rapidly in recent years in Europe, North America and Asia. They typically are referenced to a market index, covering bonds, stocks, commodities, even relatively hard-to-enter asset class areas such as infrastructure. There are ETFs which make money in a down-market – so-called “short” ETFs and leveraged ETFs which are designed to amplify index performance.

iShares, the world’s largest provider of these products, launched a campaign entitled “Not all ETFs are created equal” more than two years ago. (To view a feature on the issue and the profusion of exchange-traded products, click here).

Smith said that with “synthetic ETFs”, performance can diverge from the behaviour of an underlying index, which will disappoint unprepared investors.

For example, with an "inverse ETF" that is designed to make money when an index goes down, large losses can arise from an adverse market shift, particularly when investors remember that returns are compounded daily, he said. "In a week where the index was volatile on the downside but got back to par by the end of the week an inverse ETF with daily compounding would turn in a 70.5 per cent loss," he said.

As wealth managers and other investment professionals have been hit by rising regulatory costs and greater client demand for value for money, low-fee products like ETFs have gained further traction.

Last year, Credit Suisse, for example, argued that ETFs are helping to drive the shape of the wealth management industry, helping small boutique advisors to challenge the once-dominant position of big wire-houses in the US, for example.