ETFs respond to charges

The UBS rogue-trading debacle, which has fuelled calls for a clampdown on exchange traded funds (ETFs), came to light at a critical time for the $1,400bn (€1,026bn) ETF industry, as various regulators have been considering proposals to tighten rules governing the instruments, with an emphasis on the risks in synthetic replication.

Delta One trader Kweku Adoboli has been charged with fraud for the $2.3bn loss, the true magnitude of which, according to a UBS statement, was “distorted because the positions had been offset in our systems with fictitious, forward-settling, cash ETF positions, allegedly executed by the trader”.

However, even before there was any evidence of the nature of Mr Adoboli’s trades, ETF critics were having a field day. Terry Smith, chief executive of money brokers Tullett Prebon, a long-term ETF critic, asked: “What if such ETF trades cause such a mammoth loss in a counterparty which does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer – the ETF will fail.”

Mr Smith also argues that the ETF sector is deceptively profitable for providers owing to margins in the derivative trades, that ETFs do not always behave in the way investors expect, particularly leveraged and inverse funds which can move completely contrary to expections and that hedge funds buying ETFs to go short, are sometimes up to 1000 per cent short.

Ironically, in the weeks before the scandal came to light, the pro-ETF camp had made some progress in the PR battle by pointing out the hidden, unmonitored risks relating to collateral in other popular investments. In particular, some 50 per cent of mutual fund managers are taking similar risks with investors’ money by securities lending, according to research by SCM Private, a UK wealth manager that builds portfolios from ETFs.

“Current self-interested debate on the dangers of ETFs would seem about as fair and impartial as the Salem witch trials,” says Alan Miller, SCM Private’s founder.

“The debate over synthetic exchange funds has missed the point that numerous other retail products have similar risks, namely over 50 per cent of unit trusts, most structured products, the entire spread betting industry and most physical exchange funds. Some of the negatives that ETF bashers are bleating on about are far more prevalent in other products,” he explains.

“The FSA’s comments in June that synthetics ETFs might not be suitable for retail investors is pretty random when some of the same risks apply in mutual funds, particularly in absolute return funds, none of which declare the precise level of counterparty risk as ETFs do,” adds Mr Miller.

The European Securities and Markets Authority (Esma) has issued a consultation paper primarily looking at synthetic ETFs and counterparty risk, and invited comments by mid-September. It is also reviewing index-tracking issues, costs, the quality of collateral held, actively-managed and leveraged ETFs, and how certain ETF structures allow credit institutions to raise funding against relatively illiquid assets.

Many providers already meet Esma’s likely requirements, for example by using multiple counterparties and publishing the details of collateral. “ETFs are tightly regulated,” says Manooj Mistry, head of db x-trackers, UK.

“By meeting Ucits standards, and by having an independent custodian, asset manager and administrator in place, this ensures there are no conflicts of interest. db X-trackers was one of the first mutual fund providers to let investors access daily updated, fully granular data on the collateral on all of our products. The collateral backing our swap agreements is of high quality. Only blue-chip equities and minimum investment grade bonds from developed countries can be used, for example. Of the bonds used as collateral across our fixed income ETF range, around 70 per cent are triple-A rated.”

iShares, which offers just three synthetic funds covering the Indian and Russian markets and a commodities product, also points out that its exposure is over-collateralised with high grade liquid holdings, and it publishes details of the collateral details and relevant swap spreads on a daily basis.

“We’ve seen an increase in the demand for physically backed ETFs as investors are looking for straightforward exposure to an asset class, and it is very easy for advisers to explain exactly what the investor will be holding when they sell it to clients,” says Feargal Dempsey, head of product strategy at iShares.

Most of the excitement in ETF product development is around active managers. Pimco is making waves with plans to launch an ETF version of its Total Return Fund, the portfolio overseen by bond guru Bill Gross.

Many niche product offerings are becoming quite sophisticated. Funds based on, say, currency strategies, hedge funds or active funds may be a challenge for the retail investor to understand, but leveraged and volatility funds may be nigh impossible for the layman to evaluate.

Many professionals avoid leveraged funds and providers such as DB have taken the decision not to market them to retail investors. At HSBC Global Asset Management, for example, fund manager Stephen Doran says leveraged or inverse funds “are more suitable for day-traders – their ‘path dependency’ means the return can vary from expectations over extended investment horizons, and in 2008, many leveraged ETFs failed to meet investors expectations”.

There has also been a steady trickle of hedge fund products, but Mr Doran says in performance terms these tend to deliver an average hedge fund return, although the attraction of circumventing the hassle of opening an account at a hedge fund and of intraday trading at NAV are both appealing.

One interesting product is Man’s GLG Europe Plus Source ETF, which uses algorithms to trade on brokers’ buy recommendations. Hundreds of recommendations are aggregated and rated. According to Morningstar, the strategy has been used in a long-only equity fund and has outperformed the MSCI Europe TR Index for the last three years. It is similar to Marshall Wace Asset Management’s system for its Tops program, but unlike Tops, it does not trade on sell recommendations or use leverage.

“There is a lot of focus on the structure of ETFs rather than the index, which to my mind is really the heart of the product,” says Thibaud de Cherisey, head of European ETF development at Invesco Asset Management. “In future, more alternatives indices will be used and the main underdeveloped asset class is fixed interest. Most fixed interest indices are constructed in the same way as equity indices using market cap, but that is not at all logical for fixed interest because it tends to favour the more indebted companies.”

Powershares RAFI funds make use of fundamental weightings focusing on the strength of the company rather than looking at its price, using four metrics – sales, dividend, book value, and cash flow. “Together these give you a good view of the quality of the company, not an expectation of price but the reality of the company,” says Mr de Cherisey.

Another attraction is that this analysis is conducted once a year, rather than trying to keep up with a fixed interest index with ever-changing constituents. “RAFI fixed interest ETFs have just been launched in the US and could have a great potential in Europe,” he says.

Many wealth managers use ETFs for short-term tactical asset allocation calls, for large liquid indices in efficient markets and for illiquid markets such as private equity, preferring active managers for markets such as small caps, where in theory the manager should be able to add most value. They tend to use synthetic ETFs if the asset class is illiquid or where a tracking error will occur owing to the diffuse nature of the underlying, such the MSCI World.

As the variety of ETF structures widens, investors are focussing more keenly on the due diligence offered by their advisers.

“Providers are expanding the universe, which generally means using swap-based products to gain access to less liquid markets, but the negative of that is that ETFs could become more confusing for investors,” says Nathan Bance, director of investor solutions at Barclays Capital. “This has created the need for an extra layer of analysis so more wealth managers have been allocating a research person to specifically look at ETFs, whereas a couple of years ago the research teams were typically split by asset class.”

In the past, whether a wealth manager was allowed to invest in ETFs was generally at their discretion, but now it is such a broad term and investors are demanding greater due diligence, explains Mr Bance. A multitude of issues fall out of collateralisation alone.

“Wealth managers are under pressure to keep costs down and not to allocate to active managers unless they deliver, so they will buy ETFs in areas they are less confident of finding good managers such as US equities,” he adds.

There has been much greater use of ETFs on platforms as wealth managers develop model portfolios, particularly if they are trying to build risk-rated solutions which push in the direction of an ETF, because investment manager risk is then excluded and products can be more benchmark index driven.

Jonathan Clatworthy, Investment Manager at Arbuthnot Latham & Co, says a saving of just 20 basis points can be made in selecting synthetic ETFs over physical ones and this is not worth the additional perceived risk.

He changes the instruments used depending on the stage of the cycle. He currently believes that active managers are best placed to benefit from the economic climate, but “in the second half of 2009 for example, the market rallied but most active managers got left behind; they were too slow to realign,” he says, and management fees detract from performance when the whole market rallies in unison, creating an argument to use ETFs in the first stages of a bull market.

“We are moving into a later stage recovery now, and I expect markets to move away from being most influenced by the macro- background, to being more influenced by micro factors, which is a backdrop better suited to active management,” says Mr Clatworthy.

Where there is little disagreement in the EFT debate is the need to differentiate true ETFs from exchange trade notes and exchange traded commodities, which are not subject to Ucits rules and therefore are not bound by the organisational and risk management requirements.

“The ETF acronym is used for them all,” says Perry Braithwaite, adviser on product regulation at the Investment Management Association. “While in many circumstances investors may notice little difference between an ETF and a note, if something goes wrong they may have less confidence about what assets they are invested in and to what risks they may be exposed.

“Exchange traded notes fall under Mifid in how they are distributed and sold, and will also be subject to the listing rules of their exchanges, but, unlike Ucits ETFs, they are not required to have an independent depositary whose role is to protect the assets of the fund and to look after the interests of investors,” adds Mr Braithwaite.