Product quality threatened by lack of transparency

As March marked the 10th anniversary of the first exchange traded fund (ETF) in Europe, the industry, which will grow by 30 per cent annually to reach $500bn (€400bn) of total European assets by 2012, finds itself at an important crossroads, believes Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock.

Investors’ perception of these passive instruments, which aim to replicate the performance of an index and have increasingly grown in popularity thanks to their liquidity and transparency characteristics, risks being poisoned by those products that call themselves ETFs but that do not even have the basic features of an ETF.

“We are seeing funds calling themselves ETFs which do not provide transparency on their underlying portfolios, do not offer in-kind creation/redemption and do not have real time indicative Net Asset Values. Products which are not even funds are being called ETFs,” says Ms Fuhr.

The booming growth in an industry which broke the $1,000bn global assets under management milestone at the end of last year, is leading product developers to work hard to find ways to put structured products, hedge funds and active funds into an ETF wrapper, without maintaining the basis features of an ETF. “If this is allowed to continue, we risk confusion, disappointment and disillusionment among investors, which would be very negative for the industry,” she warns.

Confusion is aggravated by the increasing number of repetitive products available to investors in Europe, as providers continue to launch similar products tracking the main indices, while listing them on multiple exchanges. For example, there are now 34 products with 115 listings tracking the Euro Stoxx 50. Some US leveraged and inverse ETFs, which the US regulator, the Financial Industry Regulatory Authority considered not appropriate for retail investors, have been listed in Europe, and people do not even realise they are US domiciled funds, which may not be very tax efficient, she says.

Greater transparency around product structure, index replication methodology, pricing and counterparty risk is vital to help investors make informed investment decisions, when considering ETFs.

Agreeing definitions for all kind of ETFs and ETF-type products on the market is one of the growing needs in the industry, says Ms Fuhr. “I really think there needs to be an agreed set of definitions that are embraced globally, so investors can differentiate between the various product structures, between a product that is tracking an index and it holds physical underlyings, versus another category of products which are swap based, and there should be clarity about the swap counterparties and what is the collateral.”

Other categories should be exchange traded notes and other structures including grantor trusts, partnerships, or commodity pools. “I am hoping this will happen over time and Iosco, which is the international securities regulator, will do something to really make this clarity of definition become reality.”

Room to innovate

Dan Draper, global head of ETFs at Credit Suisse, believes innovation in the ETF space is not necessarily giving access to a new asset class, to a new geographical region, or a new sector, but rather “there is still tremendous scope for innovation in terms of quality and education to clients.

“I think there has been a much higher degree of emphasis on pure distribution and selling with everyone hoping that the ETF name and brand is good enough. This has taken priority over the asset management aspects, to make really high quality products that are fully transparent in terms of tracking error and in terms of the actual holdings of the ETFs.”

Mr Draper believes the argument of swap-based versus physical replication is one that became convenient for some participants in the industry during the credit crisis. It was really useful from a marketing perspective but it had more of a confusing impact than anything else. “Both replication methods, swap-based and full replication, are valid, and both gathered significant assets even in the teeth of the credit crisis. The onus is on the ETF issuers to be transparent about how well they are tracking the index, what their replication strategies are and really help clients understand and quantify what their risk exposure may be.”

These risks include the counterparty risk, typical of the swap based replication method, or the risk involved in securities lending, typical of the full replication method, although there are many debates on whether the two risks are equal. Once made aware of all the risks, investors are in the position to choose. “I think an integrated approach [to index replication] probably makes sense,” says Mr Draper, who recently joined Credit Suisse, where ETFs use physical replication, from Lyxor, where ETFs are swap-based.

It is also important to refine inconsistent data. For example, the concept of tracking error, which measures the amount by which the performance of the portfolio differs from that of the benchmark, can be calculated in different ways and it is tempting for an issuer, from a marketing perspective, to choose the method that is most favourable to the way they make the ETF, but it is not consistent with other issuers, explains Mr Draper. At European level, independent organisations such Efama should really take the lead on these issues, he believes.

Bradley Kay, Morningstar

The broad proliferation of products and enormous amount of cross listing happening in Europe is leading to fragmentation of liquidity, which may contribute to hinder the growth of the retail market, says Bradley Kay, head of European ETF research team at Morningstar, based in Chicago. “If you want mass entry by advisers and retail individual investors, liquidity is an issue that needs to be addressed,” he says.

Fragmented market

The smaller average size of an ETF in Europe – which is just a third of that of an exchange traded fund in the US ($245m in Europe versus $840m in the US) – is clearly indicative. This fragmentation is partly due to the fact that Europe is not a single market, but there are multiple currencies and different tax systems to take into account. ETFs are listed on multiple exchanges, with many products tracking the main indices.

So far liquidity problems have not become too widespread in Europe, says Mr Kay, because 90 per cent of the total ETFs assets under management – $234bn – are held by institutions, and only 10 by per cent by retail investors. This is different from the US, where the split of the total $764bn ETF assets is roughly 50-50.

Unlike large institutions, which trade over the counter (OTC), ie they go to market makers for all their large block purchases or sales rather than going on exchanges, retail investors, who trade in small sizes, have to rely on exchange liquidity. While in the US about 60 per cent of total trading volume is OTC, with the remaining 40 per cent on exchange, it is estimated that in Europe only 6 per cent of the ETF turnover is on exchange, leading to much wider bid-offer spreads and lack of transparency.

One way to improve liquidity would be to incentivise the use of ETFs by hedge funds, says Mr Kay.

“Hedge funds were the real boon to the US market, because ETFs are the perfect vehicle for short-term data exposure. Hedge funds do tend to be turning around very rapidly and produce a lot of trading liquidity. Also, they generally want to trade on exchanges as they want to keep their costs as low as possible, they don’t want to pay market makers to get in an out of their positions,” he says. However, on-exchange volumes will have to grow before hedge funds can make more use of these instruments.

Short positions

Initiatives from Source, the investment bank-owned platform for exchange traded funds, and Morgan Stanley in particular, which is one of the three original shareholders of the platform, are helping push things forward. Source launched some sectors ETFs, designed to suit hedge funds that frequently want to short sectors as part of their trading strategies, and programmes have been promoted to make shorting ETFs easier.

“Shorting is really what hedge funds like using ETFs for, as it is much cheap and easier to short an ETF than buying the swap directly from the investment bank,” says Mr Kay. And, on the other side, ETFs are cheaper than holding all individual swap positions with each player for the investment bank too. Europe once again lags the US in trading volume. Whereas in Europe only 1.5 per cent of the entire assets in ETFs turn over daily, in the US it is about 10 per cent, and hedge funds account for some 50 or 60 per cent of trading volume.

Having been active in manufacturing and lending Source ETFs since the launch of Source platform last year, Morgan Stanley recently announced the launch of a “create-to lend” book of business for European ETFs, where it will create ETF units specifically to lend to investors for selling short.

“In the US, investors who want to take short positions in ETFs find it generally quite easy to do so. There is a very deep and liquid market in the borrow market certainly in the plain vanilla underliers, you can borrow large amount of these shares at very reasonable cost,” says Matthew Tagliani, head of ETF product for Europe & Asia at Morgan Stanley.

“That market did not exist in Europe, even in the funds that have multiple billions in assets under management; it has historically been difficult to be able to short ETFs, partly because investors that use ETFs in Europe tended not to be as active in the lending programmes.”

Barclays backing exchange traded notes to fill gap in European market

Exchange traded products, such as exchange traded commodities (ETCs), exchange traded currency (ETCs) and exchange traded notes (ETNs), which have similarities to ETFs in the way they trade and settle but are not funds, have grown considerably in recent years, although ETPs’ total assets under management are currently only 7 per cent ($16.8bn/E13.6bn) of the total AUM in ETFs ($234bn) in Europe.

To be Ucits III compliant, a fund has to meet specific regulatory requirements in terms of diversification of its portfolio holdings, while ETPs can meet investors demand to track performance of, say, one single underlying.

Exchange traded products, or certificates in general, are debt securities issued by a company, which could be a special purpose vehicle. Although they may not enjoy the superior regulatory oversight of Ucits III, ETPs, in general are a big improvement over the certificate business, as they are traded on exchange daily and the investor does not need to go back to the same issuer to sell the product, like in the case of the certificate.

One of the firms which is pushing ahead in the ETN business is Barclays, which has recently launched its first exchange traded notes, the iPath ETNs, on the London Stock Exchange, providing investors with exposure to commodities and volatility.

“The reason why we have brought ETNs to Europe is about transparency,” says Uwe Becker, head of investor solutions Europe at Barclays Capital, pointing out that the investment bank has 70 per cent of market share in the ETN business in the US. “Investors really appreciate the ease of the due diligence and risk assessment for our products. We expect the ETN market to grow substantially, as investors seek efficient new ways to diversify,” says Mr Becker.

Unlike other ETNs issued by other entities who need to collateralise their products to provide investors with some protection and limit counterparty risk, Barclays iPath ETNs are not collateralised as they are issued directly from the bank’s balance sheet and this way they cut down the number of counterparties involved, he explains.

“This is the beauty of the product, because it is immediately clear to investors what their risk is: it is Barclays Bank plc. As an AA issuer, which has always been profitable throughout the entire financial crisis, Barclays puts the word counterparty risk into prospective,” he says.

These passive products tradable on exchange deliver the return of the index which the product tracks, irrespective of the fact whether Barclays as a bank is able to source that performance in its own trading books, so the investor gets the index performance with zero tracking error, says Mr Becker. Although the product does not fall under Ucits regulation, it is Ucits compliant, so that Ucits funds can themselves invest in ETNs. Barclays is not aiming at competing with existing ETFs but its goal is to complement the existing ETF product offering.

“We are looking at the gaps in the ETF world, at markets that are not available in the ETF world or come with high expenses or poor liquidity, and we are trying to replicate those markets in an ETN wrap,” he says.