Consultancy firm Watson Wyatt has cast doubt on the appeal of exchange-traded funds, calling them an “unattractive long-term investment option for most institutional investors.”

According to the consultant, while ETFs have opened up a world of potentially interesting market exposures, they “generally have higher fees than many institutional index products; may have tax implications that require specialist advice; and often contain counterparty risks which investors may not be compensated for.”

The criticism of unrewarded counterparty exposures within ETFs is not new. A year ago at a conference at the London Stock Exchange, Chris Sutton, senior consultant at Watson Wyatt, described securities lending as “picking up pennies in front of a steamroller”. Sutton was chief executive of iShares Europe and a director of parent company BGI before joining the consultancy firm in 2007.

However, Watson Wyatt’s assertion that “most investment strategies can also be implemented more cheaply and efficiently using index funds, index futures or swaps” calls ETFs’ attractiveness into question at a more fundamental level.

Furthermore, the consultant argues that most (non-ETF) passive funds have been structured with clearly defined tax positions for institutional investors whereas the treatment of ETFs is much more variable, which typically necessitates tax advice.

In its statement on ETFs, Watson Wyatt also suggests that investors should be aware of recent developments within indexation.

“Capitalisation-weighted portfolios are not necessarily optimal, leading them [investors] to contemplate shifting significant assets into alternative weighting approaches,” notes Sutton. Watson Wyatt has been at the forefront of those recommending that index investors look beyond capitalisation weighting as an index construction methodology, publishing a paper on “beta prime” index exposures in 2007.

“Where the ETF industry has engaged in product proliferation, we would rather press for genuine innovation in the investment content of index products. If investors are looking for more efficient market exposures, their first step should be to review the indices underlying their existing investments with a view to seeing if there are better alternatives,” said Sutton.