Booming ETF industry faces construction issues

At first glance, it appears Europe’s exchange traded funds (ETF) industry has never had it so good. Lyxor figures from February 2012 saw assets in exchange traded products peak at €248bn, with emerging markets and commodities contributing to regular monthly inflows in the €2bn range.

But a closer look sees a previously harmonious marketplace polarised by a divisive debate about the construction of heavily-traded instruments, now typically held for weeks rather than months. Should investors be guided into funds which physically match an index, or is it fair for them to be sold synthetic funds, using swaps to approximate holdings of companies?

During 2011, as European regulatory bodies queued up to criticise the product design and risk implications of some ETF structures, derivative-based ETFs endured a tough year.

While physical ETFs attracted $25bn (€19bn) of net inflows during 2011, their swap-based rivals registered net outflows of $4bn, according to HSBC. Moreover, assets held in physical ETFs grew 4 per cent, while swap-based ETF assets fell 13 per cent.

A recent annual letter to shareholders from Terry Smith, a long-standing, vocal character in the City of London and chief executive of Fundsmith set the scene, apparently blowing holes in the widely-held belief that ETFs are simply transparent funds which track an index.

“Synthetic ETFs do not hold underlying securities of the sector or market they are supposed to replicate,” writes Mr Smith. “Inverse ETFs can lose money even when the market sector they track has gone down, and leveraged long ETFs can lose money when their market or sector has gone up. None of these is consistent with the performance of a simple index fund.”

Even a cursory look at the marketing literature of synthetic ETF funds should send investors running for cover, suggests Mr Smith. “If a fund which is described by the words synthetic, derivative, swap and counterparty does not cause you obvious concerns, I suggest you may need to study the events of the credit crisis of the past four years more carefully.”

THE RIGHT MIX

In practice, many wealth managers use a mix of physical and synthetic. UniCredit Private Banking, for instance, uses ETFs with full replication where possible, in order to minimise imbedded counterparty risk, says the bank’s head of fund selection, Jean-Francois Hautemulle.

“But we are also aware that there are some niche asset classes that can only be accessed through synthetic ETFs and have therefore made the conscious decision to use those in a tactical manner.”

For many, the debate has been overhyped, because risks are associated with both classes of product, particularly as some physical ETFs lend stocks to third parties. The key question for investors, says Hans Hamre, global equities director at BNP Paribas product selection unit Fundquest, should be whether risks are controllable. “Investment is not about blind risk avoidance, it is about making an informed choice between risk and return,” he says.

FundQuest practitioners agree that the synthetics debate had a significant impact on fund flows. But these trends are disputed in other quarters. “I am not sure the data supports the assertion that there was a migration of assets from synthetic to physical providers based on whether they use derivatives,” suggests Michael John Lyttle, managing director of Source, who reports conversations with ETF users which highlighted an excellent understanding of risks.

“The conversations that we had with ETF investors indicated that they understood that all financial products run some form of counterparty exposure and the key is how that exposure is managed and disclosed,” adds Mr Lyttle.

At the heart of liquid markets must be the premise that investors are able to transact business and have confidence in legal title. “There is a risk with synthetic ETFs that delivery of the rights and benefits of ownership fails, but there are also risks with so-called physical ETFs,” points out James Bevan, head of investments at CCLA.

“We should not assume that swaps are inherently more risky than physical stock trading in all market conditions, particularly if we define risks as the potential for failure to achieve our objective.”

At the end of the day, believes Mr Bevan, it is down to the owners of the assets do determine the way forward. “The private banks and wealth managers offer propositions that can be accepted or rejected by their clients,” he says. While the business models of manufacturing investment banks – often linked to private banks as distribution channels – may prefer delivery through ETFs, it is ultimately the end investors that determine what happens at the coal face.

CLIENT DEMAND

Indeed, wealth managers have not really kept pace with the desire of clients to lodge substantial part of their portfolios in liquid instruments. For some time, wealthy individuals have been pushing reluctant banks into providing low-cost ETF-based solutions, reckons Sebastian Dovey, founder of wealth management think-tank Scorpio Partnership.

“There are clear points of view on the investment merit of ETFs, but the argument of cost relative to investment market exposure was typically the deal closer for most investors,” says Mr Dovey.

UBS was the bank which pioneered a populist model of core-satellite investment for discretionary portfolios at the beginning of 2009, allocating 20 to 50 per – basically the equity core of the portfolio – to ETFs.

Now the Swiss bank is naturally reluctant to comment on these issues, with fraud charges against a UBS ‘Delta One’ trader following a $2.3bn loss, leading to calls for a regulatory overhaul of ETFs last year.

But these mass initiatives certainly caused ripples across Europe’s wealth management industry, which was busy re-inventing itself to preserve the loyalty of twitchy clients, unnerved by the financial crisis and portfolio management losses. Core-satellite ETF-based portfolios are finding favour with cost-conscious investors, despite suggestions from equity specialists such as Schroders that long-term active holdings should now form the core of portfolios, with fast-trading ETFs confined to the fringes.

“We are still cautious on ratcheting up expenses,” says Alan Higgins, chief investment officer at Coutts private bank. “If you have active as core and specialist trades as satellites, you end up with very expensive portfolios for wealthy clients. You have to be humble to the fact that stockpicking, by its nature, makes it very difficult to win.”

This trend of using ETF-based portfolios is receiving some recognition in the mainstream. Strategists at Source believe broad benchmark ETFs are natural core positions, with a collection of outperformance and country/sector specific ETFs offering useful satellite tools.

“With more and more ETFs available in Europe on various emerging markets or specialised exposures, it is now possible to fully implement core-satellite strategies through ETFs and at a lower cost than with actively managed funds,” claims Armelle Loeb-Darcagne, director of ETFs Emea at HSBC.

“More and more investors are now convinced that performance comes mostly from asset allocation. The index versus active discussion is an old and stale debate. We believe the solution is not whether to use one or the other, but to leverage the strengths of both and blend them effectively.”

The key for most investors appears to be deciding which investments are best suited to ETFs and which are best outsourced to active management specialists.

“If you want to make a tactical bet in a hurry, and have not yet chosen a manager or the right mix of managers for that bet, then you can do it tomorrow morning by picking up an MSCI index tracker,” comments Adam Wethered, co-founder of private investment office Lord North Street. “But you might want to use one based on underlying stocks rather than derivatives, in order to avoid credit risk,” he warns.

Emerging markets, for instance, are probably best bought through active stock selection. “ETFs are a useful proxy in big liquid markets such as US equity,” says Mr Wethered. “But they can struggle in exotic markets to hug the index.”

One particular example of widespread – some say inappropriate – use of ETFs in Europe saw high-yielding fixed income ETFs attract $6.6bn of net inflows during the first two months of 2012. But some of these funds underperformed their indices by more than 5 per cent a year.

“Fixed income ETFs tend to have a higher tracking difference than equity ETFs, but this is mainly due to the over-the-counter nature of the underlying bond market,” says HSBC’s Ms Loeb-Darcagne.

“The process of price monitoring for bonds is not as straightforward as it is for equities. Prices used to value the indices are indicative and it is not always possible for passive portfolio managers to trade at these prices, creating a mechanical tracking difference to the benchmark.”

While HSBC expects active funds to exert a dominance of more than 90 per cent of the market for now, it also predicts a sustained growth opportunity for passive investments in the years to come. “I think ETFs will more and more be used alongside active funds for tactical investments as well as strategic allocation,” says Ms Loeb-Darcagne.

According to Source, ETFs are a fundamentally “disruptive technology,” which will continue to take market share from traditional funds, “by offering the same quality of construction as traditional Ucits fund, but with the addition of daily liquidity and transparency”.

RISKIER THAN THEY LOOK

Yet other industry commentators warn providers not to get carried away. “ETFs are viewed as a principal means of riding the volatility wave. As such they can be far more risky than their staid image suggests,” says Amin Rajan, CEO of consultancy Create-Research. “Increasingly, institutional investors have confined them to the risk end of their portfolios.”

Mr Rajan also warns that some ETFs use derivatives to spice up performance by borrowing to bet, and relying on this leverage to deliver a multiple of daily index returns. In conclusion, he says, ETFs have become popular not due to their innovative nature, but because active managers have failed to deliver on their promise of the last decade.

“ETFs have yet to succeed in their own right by delivering their own promise,” says Mr Rajan. “They will become a fixture for sure, but most likely as one of the satellites around the portfolio core. They will retain their appeal as a liquid asset allocation product that permits tactical tilts. But they should be a component within a portfolio, not the centrepiece.”

ETF selection

The days of significant resources being earmarked only for selection of active mutual funds by private banks, with ETFs just bought blind as a commodity, began to fade with the fears of counterparty risk, induced by the onset of the 2008 Lehman-led financial crisis.

“Until a few years ago, we felt that generally, most professional investors were seeing and using ETFs more as stocks than funds and selecting them based mostly on their on-exchange liquidity and size than on the structure and risk profile,” says HSBC’s Armelle Loeb-Darcagne.

But since counterparty risk became more tangible to investors in 2008, clients became more conscious of the need for more detailed selection criteria. At Fundquest for instance, there is a mantra, “an ETF is not just an ETF,” among product selection specialists.

“A clear process is needed for the assessment of ETF providers and the funds that they offer,” says the group’s director of global equities, Hans Hamre. But this perspective must be very different from that used for selecting actively managed funds. Rather than focusing on the behaviour of the portfolio manager, the focus needs to be more structural, assessing the ETF provider’s business model, the size of their product range, the design of products and internal risk control procedures.