Exchange traded products are the investment industry’s answer to the unpredictability and expense of traditional fund management. Combining the simplicity of single stocks with the latest index-tracking technology they are the investment success story of the past 20 years, growing from nothing in 1990 to over 2,000 products globally today, worth more than $1.2 trillion.
For advocates, ETFs are a panacea, offering a high degree of flexibility with transparency evidenced by the frequent publication of holdings, often on a daily basis. They offer a variety of financial exposures, from specific stocks or sectors to unusual geographic locations and illiquid securities. In short, they are a perfect diversification vehicle and the shiny one-stop solution for the convenience investor of the 21st century.
Still dancing?
Aside from the odd sniping article in the trade press, there was little until this year to upset ETFs serene progress onto the favourite playlists of the retail investors, private banks and asset managers worldwide. The sector was growing 40% a year. Then just as the party was reaching its peak, the Financial Stability Board (FSB) stepped in and turned off the music.
In a brief and austere document published in April, the Basel-based regulatory supervisor identified “potential vulnerabilities” and “financial stability issues” arising from ETF trading.
All of sudden it was open season on ETFs. The sniping commentators brought out the bazookas, the academics sharpened their pens and the conference organisers saw an opportunity. Even the Financial Times join the bandwagon, with editor Gillian Tett writing that the sector’s growth reminded her of the credit derivatives boom, and was “in the grip of a wave of investor enthusiasm that risks turning a fundamentally sensible innovation bad”.
Before long the august institutions of financial oversight were wheeling out their own particular perspectives. Over the spring and summer there appeared weighty contributions from the Bank of England, the Bank for International Settlements, the European Securities and Markets Authority (ESMA), the European Systemic Risk Board and the IMF. From new kid on the block, ETFs were swiftly transformed into dangerous scoundrel and potential lunatic.
Fundamental analysis
Amidst the beating of chests and tearing of hair, there emerged from the less hysterical corners of the financial community, a number of specific questions that appeared worthy of qualifying, and potentially quantifying.
Central to these was a differentiation between two fundamental ETF structures -- the physical product, backed by real assets held by the provider; and synthetic funds, which recreate the returns on an index through a swap agreement with an investment bank, usually the parent of the ETF provider. It was this later class which attracted a large proportion of critical attention.
Probably the biggest source of structural risk in synthetic ETFs is counterparty risk. In ETF terms, counterparty risk may be manifested in the possibility that the bank providing the swap (replicating index performance) defaults on its obligations.
While physical ETFs are more popular in the US, their synthetic cousins have flourished in Europe, where there is some protection afforded by Undertakings in Collective Investments in Transferable Securities (Ucits) legislation, which requires that no fund has more than 10% exposure to a single swap counterparty.
Additional protection can be structured into the fund – and how this is done will depend on whether the investment is funded or unfunded; in simple terms: whether or not investors own the securities underlying the fund returns.
Under the unfunded version, the ETF uses cash from investors to buy and hold a basket of securities from a swap counterparty, usually comprised of bonds and equities already owned by that counterparty. The counterparty then commits to deliver the reference index’s performance,
The key point is that the fund is the owner of the basket, to which it has direct access. That means if the swap counterparty defaults, the ETF provider should, in theory, be able to sell the assets and get back its money. “In theory” because there is always doubt over market liquidity and the value of the assets, particularly in times of market stress.
Counterparty risk here comes down to the difference between value of the ETF and the value of the basket. Given that Ucits regulations limits the exposure to the counterparty to 10%, the value of the basket must not fall below 90% of the value of the ETF, and the law requires that if it does the swap counterparty must provide funds to buy additional securities for the basket (a so-called swap reset).
It is at this point that the world of ETFs can become somewhat murky. In the relationship between the basket value and the swap reset there is some wiggle room for swap providers. For example some may guarantee to reset swaps daily, while others do so less frequently.
A few apply stricter triggers than the Ucits 10% requirements, while others wait for the value of the basket to decline a full 10%. Also, some may reset the swap to zero, leaving no opportunity for counterparty risk, while others sustain a mismatch between the basket and the net asset value of the fund.
Providers of unfunded ETFs include Amundi, Easy ETFS, Lyxor and Credit Suisse. Credit Suisse resets its swap daily to zero while Deutsche Bank resets its unfunded swaps to zero when the swap value reaches 5% or there is a creation or redemption. Lyxor, meanwhile resets when the counterparty exposure gets close to 10% and rarely resets to zero.
Funded ETFs
The funded swap model was introduced in Europe in early 2009, and differs from its unfunded counterpart in that the fund’s cash is transferred to the swap counterparty (which guarantees to pay the return on the index) and the counterparty posts collateral in a segregated account with a third party. The account is “pledged” in the name of the fund, and it is in the strength of the pledge through which investors may differentiate providers.
The collateral in the funded model again comprises securities owned by the swap counterparty, and may be equities, bonds or other assets. Generally under the funded model the level of collateral is kept at least at 105% of the value of the fund, with the exact amount varying between providers. Providers of unfunded ETFs are critical of the collateral arrangements of funded ETFs, which they say can cause liquidity issues if swap counterparty defaults.
“The issue with the funded model is that you don’t own the assets,” says MJ Lytle, director of marketing at unfunded ETF provider Source. “That can lead to problems and in our view the funded model is rapidly disappearing.”
A key consideration for investors in both synthetic models is what securities are contained in the collateral basket. Providers apply wildly varying sets of criteria to what can be included, with some sticking to government bonds and others allowing all sorts of securities of different types, sources and credit quality. They very rarely match the index.
Deutsche Bank, the largest provider of ETFs, collateralises db X-trackers with eurozone large cap stocks for equity ETFs and three-month treasury bills for fixed income funds, while ETF Securities funds are backed by developed market equities and various types of bonds.
The crucial question for investors is simple: Will the fund be able to sell the securities at a good price and quickly if the counterparty defaults? If the answer is in the negative or is uncertain, investors should beware.
“What you really need to make sure you know is what you are getting,” says Peter Doherty, chief information officer of Tideway Investment Partners in London. “What you do not want is to buy an index tracking US bonds, and then find what you actually have is a basket of Japanese equities”.
Responding to criticism
After criticism over levels of transparency in synthetic ETFs, some providers have made efforts to publish details of the composition of collateral baskets, with some now disclosing on a daily basis, as well as increasing collateral levels and moving to more frequent swap resets.
“The next great step is toward greater harmonisation of these practices, which will facilitate easier comparisons,” says Ben Johnson, director of European exchange-traded fund research at Morningstar. “At the moment that is a pipe dream, but a goal of perfect harmonization may at least lead to some steps in that direction.”
If providers were able to benchmark their products, it would provide a strong incentive to increase allocations to ETFs, investors say.
“While at the moment you get fact sheets for individual products, what you don’t get is qualitative assessments of one ETF against another,” says Lothar Mentel, chief investment officer at Octopus Investments. “It would be great to be able to track reliability of performance of the swap, instead of relying on the goodwill of the bank to make these things track perfectly.”
Away from the synthetic space are physically-backed ETFs, where there is no swap and the ETF manager simply purchases the underlying assets of the index. Despite being viewed as a less dangerous cousin, physical ETFs are not without their own issues. These lie, in particular, in the widespread practice among physical ETF providers of securities lending, which in some cases can amount to 100% of the securities in the fund.
“With a synthetic product you start with an imperfect basket and make it almost perfect by overlaying a swap,” says Morningstar’s Johnson. “In the case of physical, you start with a basket that is almost perfect and making it imperfect by securities lending. In both cases you are exposed to counterparty risk.”
The amount of revenue earned from securities lending depends on the number of securities lent, as well as the level of demand for those securities, and the amount and quality of collateral posted against those loans. As in the synthetic markets, there is also a risk associated with collateral transformation, likely to be required during periods of market stress.
In order to offset the risks associated with securities lending, some ETF providers, including HSBC and UBS, offer indemnities against borrower defaults. Others, such as Credit Suisse and iShares, do not.
Another issue is the proportion of income generated from securities lending actually returned to the fund. Some ETFs remit all of the income after costs, while others retain up to 50% of the proceeds, split on some undisclosed basis with a lending agent.
One of the big complaints against providers of physical ETFs is their lack of progress in being more open about the variable costs and benefits associated with securities lending. In fact, very few providers publish information on these activities -- iShares being the honourable exception.
“To some extent the synthetic industry has stepped up and addressed the concerns that are out there in respect of transparency,” says Bernie Thurston, head of Delta One Data at ETF data management provider Netik. “That cannot always be said for physical providers.”
Systemic risk
One additional source of concern in both the physical and the synthetic space is the direct link in funding terms between the banking system and the ETF market. Banks are swaps providers for ETFs and face funding liquidity risk in their normal operations, and regulators have highlighted the possibility that they will somehow play one off against the other.
“Because the collateral does not need to match the assets of the index being tracked, banks might have incentives to use the synthetic ETF structure as a source of collateralised borrowing to fund illiquid portfolios,” says the European Systemic Risk Board, in a note written in September.
“In times of stress, a withdrawal of investors from the ETF market might spill-over to a funding liquidity shock for swap counterparties. Similar concerns may rise for physical ETF using securities lending, when the collateral posted is not in cash and, especially, if counterparties are affiliated banks.”
Another issue raised by regulators relates not so much to funding liquidity as market liquidity. Given the growth of the ETF industry, there is a chance during a period of risk aversion that investors may rush to redeem ETF investments. In that case the on-demand liquidity promised by ETFs may prove illusory, with investors unable to redeem without causing dislocations in price.
Perhaps sensing the way the regulatory wind is blowing, Blackrock, the owner of iShares, has made a play in recent months of its dedication to greater transparency. The need for action has been amplified, Blackrock says, because of the emergence of a new breed of ETFs, which are less transparent and more complex than the existing stock. These investments provide either leveraged returns, increasing risk of losses or gains, or inverse returns, in which the investor is invited to take a short position on the underlying.
Aside from their prima facie higher levels of risk, leveraged and inverse ETFs typically aim to maintain a constant daily ratio of leverage to the benchmark, leading to rebalancing of exposures and sometimes significant trading costs.
In response to the growing complexity and variety of ETFs, Blackrock suggests a global standard classification system, highlighting and explaining the differences between products. For the most complex strategies the ETF tag should be abandoned, Blackrock says, reserving the mark for simple long-term retail solutions.
The ETF industry currently accounts for only around 5% of global mutual fund assets, so in relative terms is still in its infancy. For many investors the priority should be to impose discipline at the earliest opportunity, before the errant child turns delinquent.
“I hope what will come out of this debate is a set of guidelines and industry standard practices around issues like costs and collateral,” said Tideway’s Doherty. “It’s a great product but it needs a bit more transparency.”