Exchange traded funds on the ropes
The rapid rise of ETFs was in part a response to the financial crisis, but these vehicles are now coming under fire themselves
As the remnants of summer fade away across Europe, and the financially troubled continent enters another uncertain autumn, we should cast our minds back to the heat of late June in Monte Carlo.
Speakers and delegates at the annual Fund Forum talked about where the next financial scandal or crisis would come from. There was almost unanimous agreement about the predicted source: exchange traded funds (ETFs) and synthetic, swap-based products in particular. In an audience poll, almost 60 per cent of delegates said problems with ETFs posed a risk of contagion, although admittedly, that was during a sparsely attended debate, with questions posed in a leading way.
But interviewed on stage in front of a much fuller house, Larry Fink, chief executive of the world’s largest fund house, BlackRock, said the “synthetic ETF story will finish badly” because the products contain embedded leverage.
He compared the inbuilt faults and risks to those of collateralised debt obligations (CDOs), which hovered as a spectre over the industry in the months prior to the onset of the 2008 financial crisis.
Others have since waded into the fray. One heavyweight ETF critic is amateur boxer Terry Smith, chief executive of money brokers Tullett Prebon, who warns of severe counterparty risks and unpredictable behaviour of leveraged products.
Last month Mr Smith shared his thoughts with PWM readers about synthetic ETFs. He wrote: “The credit crisis should have taught investors that there is no such thing as an undoubted counterparty, so who knows if a synthetic ETF will deliver the performance of the securities it is alleged to track in periods of financial stress?”
Surveys of performance conducted by PWM during the last five years have shown some ETFs underperforming indices they are supposed to track by between one and two percentage points, which negates the whole rationale of buying them in the first place.
While it is important not to point fingers as so many other products have similar frailties, it will come as no surprise for watchers of fund management and private banking that the latest scandal emanates from the problematic world of synthetic ETFs.
Charges of fraud against a “Delta One” trader at Swiss bank UBS, following losses of $2.3bn (E1.7bn), have led to a race among regulators to step up supervision of these instruments and the Organisation of Securities Commissions has launched a probe into their possible threats against financial stability. This may result in specific targets for collateral required by ETF providers. Increased disclosure about counterparties and the type of trades they use to attempt to track indices may also follow.
Ironically, it was the extensive use of ETFs in the core of private client portfolios by wealth managers, including UBS, which led to the boom in these investments in Europe. At the beginning of 2009, UBS embarked on a new discretionary portfolio management approach to rebuild confidence among private clients.
The previous year had seen disastrous private banking outflows of SFr123bn (E100bn), harmful action from US authorities and an overhaul of top management following damage to the brand from problems in the investment banking arm.
The new roadmap involved simplification of wealth management by allocating 20 to 50 per cent of client portfolios to ETF-led investments.
Now the wealth management arm of UBS is once more forced to protect its reputation from problems which started elsewhere. The industry it helped to create – as an answer to the previous crisis – is now causing problems of its own.
