By Graham Buck

With global equity markets turning sickly in 2011, it’s not surprising that investors continue to favour the burgeoning market for exchange traded funds (ETF). The industry managed $1.428 trillion (£0.915 trillion) of assets as at 30 September, up 7.5 per cent from a year earlier, but has generally averaged annual growth rates of 30 per cent over the past decade.

Although ETFs still constitute only a modest proportion of the funds market overall, it’s impressive progress for a product that only emerged in 1993, when the first ETF was introduced in the US by State Street. Initially designed as a vehicle to passively track indices such as the S&P 500, while minimising the tax drag on investment returns from mutual funds, ETFs crossed the Atlantic in 2000 when the first European ETF was launched.

Since then ETFs and other exchange traded products (ETPs) have been
promoted by providers such as Société Générale’s unit Lyxor Asset Management, BlackRock, ETF Securities, Deutsche Bank and Credit Suisse. Barclay’s iShares division was another major name until 2009 when its asset management parent Barclays Global Investors was acquired
by BlackRock.

“In Europe ETFs are still dominated by large institutions, although we are
beginning to see a broader base of intermediaries and self-directed retail investors,” says Dan Draper, head of ETFs at Credit Suisse. North America nonetheless still dominates the ETF market; the US and Canada account for about 70 per cent, with Europe’s share at 22 per cent and Asia/Latin America having 8 per cent.

“Asia is an interesting market. It hasn’t experienced the same growth as the US and Europe as several countries have yet to buy into the ETF concept, but it will undoubtedly pick up eventually,” predicts Christos Costandinides, European head of ETF research and strategy for Deutsche Bank. Sri Lanka recently joined the ranks, after its regulator approved rules enabling ETFs to trade on the Colombo Stock Exchange.

“Around 90 per cent of Asia’s ETF market is concentrated into 10 funds, mostly Australian or Japanese, but US and European providers are trying to push into the region and develop its potential,” adds Costandinides.

Townsend Lansing, head of regulatory affairs at ETF Securities (UK) adds that the North America’s ETF investor base divides equally between institutional and retail investors while in Europe the ratio is nearer 80 per cent institutional and 20 per cent retail.

“ETFs have gained the interest of European investors because they are transparent, cost-effective and liquid,” says Lansing. This makes them increasingly popular with institutions such as pension funds, as well as private investors attracted by fees as low as 0.25 per cent.

The number of providers has also grown steadily to more than 180, although as Costandinides notes. “The figure doesn’t take into account that
the top five US providers account for as much as 90 per cent of total assets under management.”

Lansing adds: “BlackRock still has the dominant industry position in North America – and is also very strong in Europe although it has ceded some market share to a number of investment banks. There are still many providers at the tail end, managing assets of less than $10 billion.”

More providers have led to greater complexity, although many ETFs continue to adhere to the original concept of tracking indices. 2011 has been marked by a focus on instruments linked to Germany’s Dax index; of around €14 billion (£12 billion) to €15 billion of inflows into European-listed ETFs since the start of 2011 around €11 billion went to two Dax ETFs, says Constandinides.

However, over the years the exchange traded products range has steadily extended, including ETFs that derive their prices from volatility indices, and Exchange Traded Commodities (ETCs) that track the price of commodities rather than an index.

ETF Securities recently advocated a traffic light system for distinguishing between the “myriad” of ETPs and structures that have developed. So a green light could apply to the traditional, physically-backed ETPs, which own 100 per cent of the underlying constituents and do not lend any of those assets. These would, for example, include in-specie ETFs and precious metal commodity products, with no lending of either the securities or metals involved.

A cautionary amber light would apply to collateralised ETPs, which do not own all the underlying assets and use collateral to earn stock lending fees or reduce credit risk. These would include ETFs engaging in securities lending or optimised sampling, and also ETFs and ETCs using collateralised swaps.

A red light would apply to uncollateralised ETPs, involving unsecured risk to an issuer, derivative counterparty or bank. Exchange Traded Notes (ETNs), structure products, warrants and certificates would come within this group.

What has particularly caught regulators’ attention is the development of “synthetic” or swap-based ETFs. These have developed since the first synthetic, the CAC 40 ETF, launched on Euronext in January 2001. Unlike the original “physical” ETFs, which buy and hold securities in the index being tracked, synthetics rely on derivatives to replicate their performance – and in some cases have borrowed in a bid to enforce it.

Derivatives-based products now account for around 40 per cent of ETF assets in Europe and growth in synthetics outstripped that of physical ETFs in 2010. However, this year’s figures suggest that recent criticism and regulators’ scrutiny has sharply reversed the trend. In November BlackRock reported that of net inflows of $28.05 billion attracted by ETFs and other ETPs over the first 10 months of 2011, synthetics accounted for just
$1.25 billion.

Warning lights

The greater level of risk that many perceive as attaching to synthetics has already flashed warning lights at the Bank of England and the Financial
Services Authority (FSA). Reports suggest the FSA believes that the
boom in the ETF market bears uncomfortable parallels with that of the split-
capital investment trust market debacle 10 years ago and regards more complex ETFs as strictly for professional investors only. It also envisages potential conflicts of interest at the proprietary trading desks of investment banks, which might be tempted to regard ETFs as a convenient means of covering short positions.

Earlier this year the EU’s new securities watchdog the European Securities and Markets Authority (Esma) addressed the issue shortly after formation. It launched a consultation on whether new rules were required to address the risks attached to selling complex financial products to retail investors. Among the proposals was one to separate synthetics from other ETFs that are strictly regulated under the EU’s Undertakings for Collective Investment in Transferable Securities (UCITS) regime.

“Specific forms of ETFs, such as synthetics, deserve more scrutiny from the stability point of view,” commented Esma’s chairman, Steven Maijoor. “This holds especially for the issue of proper collateral arrangements when ETFs are involved in securities lending and when they are engineered on the
basis of derivatives.”

In Hong Kong, where 49 synthetic ETFs are listed, the Securities and Futures Commission (SFC) has already taken action. In September the SFC ruled that in future managers of its 13 domestic synthetics must ensure they are fully collateralised.

As it happened the SFC’s action came shortly before UBS revealed a $2.3 billion loss, from allegedly fraudulent transactions by trader Kweku Adoboli.

The bank announced that the loss was “distorted because the positions had been offset in our systems with fictitious, forward-setting ETF positions, allegedly executed by the trader.”

The synthetics issue is also fuelling a war of words between providers. BlackRock, which has only made a limited foray into synthetics, is lobbying for a standard global classification system, under which ETPs would divide into three distinct categories – ETFs, ETNs and ETCs. The group also supported Esma’s proposal to clearly distinguish physical ETFs from synthetics.

“Our preference is always for physicals,” says BlackRock’s head of product strategy for iShares, Feargal Dempsey. “Only for those cases where we can’t replicate do we use synthetics, and then we first ensure that they consist of high-quality collateral.

“So we welcome the Esma review as it addresses the issues we’ve been talking about for years. ETNs and ETCs are not regulated in the way that ETFs are, so require a greater due diligence by investors. Classification would be tremendously helpful to the industry.”

BlackRock’s CEO Laurence Fink recently turned up the heat, claiming that many investors did not fully appreciate the layers of complexity and counterparty risk that synthetics represented.

But Gina Miller, co-founder of SCM Private, says that while her firm concentrates on “the ‘plain vanilla’ ETFs”, she questions whether the more complex versions that have developed are necessarily bad.

“Some people falsely think that synthetics are more complicated than physical ETFs, yet often the reverse is true,” she contends. “There are many physical ETFs which lend close to 100 per cent of their portfolios to unknown counterparties in exchange for a basket of collateral, which changes markedly and which often can be extremely concentrated.

“Therefore a synthetic ETF that can remove the tracking error risk, has a known counterparty and is backed by a stable, well-diversified collateral basket may in practice be easier to follow and understand.”

Slanging match

Constandinides is concerned that the debate over regulation is degenerating into a slanging match between physical providers versus synthetic providers and risks damaging the industry. He also suggests that “volatile times" has meant investors stepping up their level of due diligence.

“People primarily invest in a particular ETF product because of the asset exposure that it offers them and not through fear. We should let the debate take its course and allow the experts to decide.”

The debate has nonetheless prompted a change of policy at Credit Suisse Asset Management, which held off until August 2010 before adding the first synthetics to its ETF product range. In October it announced that four of its 16 synthetic ETFs would convert to the physical model and others might follow.

“We believe that some investors have been left disappointed by overly complex investment products in recent years,” says Draper. “They are rapidly turning to investment solutions that are simple and consistent in delivering performance according to their stated investment objectives.”

Miller believes that Esma’s forthcoming debate and recommendations on the industry could have a far-reaching impact. “There has been some debate as to whether it may consider changes to all UCITS funds, rather than just ETFs,” she says. “That could have incredible consequences for many UK absolute return funds, hedge-based UCITS funds, or the countless UK mutual funds but provide practically zero transparency of such activity to investors.”

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