Concern over ETFs after problems with swaps and a warning on short trading
Part of the attraction of exchange traded funds (ETFs) is simplicity. Investors get the performance of an index or commodity, less fees, job done. However, the post-crunch environment has concentrated attention on the way ETFs are structured, particularly the underlying derivatives that back some of them.
To what extent does this represent a genuine risk for investors?
Although providers such as HSBC and iShares offer a range of so-called physical ETFs, which hold the constituents of their underlying index, many ETFs consist of swaps, which exchange the money the ETF receives for the equivalent value of the underlying index. In its simplest form, the swap-based ETF manager arranges a contract with a counterparty, such as a brokerage house, which is backed by collateral. Problems arise if the brokerage group goes bust. If the counterparty in the swap transaction defaults, investors may receive the value of the stocks that are used as collateral rather than the value of the index or commodity in which they thought they were invested.
If this happens, the collateral held by the counterparty will become important for the ETF provider. Peter Sleep, a manager of asset-allocated passive (AAP) funds at Seven Investment Management, says that this has posed a problem in the past, although not for European ETFs. In America, he says, some ETF Securities exchange-traded commodities were backed by collateral posted by AIG. When it looked as though AIG might go bust, the share prices dipped and, in one case, market makers would not trade the ETF, leaving several days with no liquidity. ETF Securities has since changed its collateral requirements and collateral is held independently. (article continues below)
There is also the problem, as pointed out by Gary Mairs, a founder of TCF Investment, that the collateral is unlikely to have anything to do with the index being tracked. Investors are effectively taking a risk on an unexpected asset, such as government bonds, rather than their original asset.
Bradley Kay, associate director for European ETF research at Morningstar, says that the situation is improving. ETF providers used to accept, for example, asset-backed securities as collateral. In some cases it might be whatever was floating about on the balance sheet. In general, it was fixed income collateral that saw the biggest problems during the crisis because it became illiquid and therefore impossible to trade and value.
Kay suggests that only about seven out of 5,000 ETF funds were affected, but it has still prompted a change in collateral requirements on the part of several ETF providers. He adds: “ETF providers will put their collateral requirements up on their websites. They are also keeping higher amounts of collateral in general, though some providers still only keep 92-93%.” He adds that while these more stringent collateral requirements should have, in theory, sent TERs (total expense ratios) higher, in most cases it has not.
Collateral is also a problem with stock lending in ETF portfolios. To generate additional performance for the fund, some funds will lend stock. This has often been beneficial to investors and some funds do not charge TER, but it brings counterparty and collateral risk. The risk for the investor is that the borrower fails to return the lent asset because during the time it is lent out it is not the property of the beneficial owner.
However, Sleep points out: “Everything has counterparty risk. There is a risk that the counterparty might not deliver. It is what you do to mitigate that risk that is important.” Also, the issue of stock lending is not confined to ETFs, it is common practice among almost all large fund managers.
Holding physical assets may seem a simpler option, but this brings its own problems. For index-based ETFs in general, ETFs based on swaps track the index better than ETFs based on physical assets.
Mairs says: “There has been a lot of research suggesting that investors get quite a large tracking error with physically-based ETFs. This is particularly true for those in emerging markets. Markets open and close at different times and this introduces tracking error. Also local investment regulation will make a difference. In India, the tax rules for foreigners alter performance and the same is true in Brazil.”
But derivatives-based exchange traded commodities (ETCs) can run into tracking error problems over the spot price (the price paid for instant delivery of a commodity). Kay points out that many ETC providers operate a rolling futures strategy, so they are never buying at the spot price. In general they are buying the right to take delivery in two to three months’ time. Most cannot take physical delivery of, for example, grain or coffee. There are storage problems, the products can degrade and it would add to the cost of ownership. As a result the majority will sell at one month.
Kay says: “This means that they are forced sellers every couple of months. There has been so much demand that it has pushed up the price of buying the two/three month contracts and lowered the cost of selling the one month contracts. Everyone else with more flexibility can trade around it relative to what the spot price is returning.”
Whole strategies have emerged to exploit these inefficiencies - for example, Armstrong Investment Managers invest in arbitrage strategies that aim to profit from the difference in price between spot and futures.
Another controversy over ETFs was generated by a white paper from Bogan Associates. This looked into the widespread practice of shorting ETFs. ETFs are used by hedge funds and other traders looking for a simple way to mitigate broad market risks, or neutralise beta, with a single trade. Some ETFs in the market are net short and therefore owners of ETF shares often far outnumber the ownership of the underlying index equities by the ETF operator.
Bogan Associates argued that this could create a run on ETFs and force a wind-up in which retail investors would be hardest hit. However, Kay argues that while naked short-selling does not exist, it is impossible for an ETF to ’fail’ in this way. He says that the standard safeguards in the institutional share lending market prevent this short-selling from creating “phantom shares” in the market that lack backing assets.
These issues are in addition to all the more everyday issues associated with ETFs such as TERs or currency, which can cause divergence from an index, but experts vary on the extent to which these things are a problem.
Kay says that it is only a problem because ETFs are the most simple and transparent product where these risks have come up. In fact, they are present in almost all mutual funds - most use derivatives and many do stock-lending - but the focus for active funds is always on how the manager is performing.
Mairs is more concerned, though not necessarily because ETFs will fail and investors will lose considerable sums, but because most investors do not understand the risks they are taking.
“It is not just stockpicking or tracking error risk. Our view is that most investors - even professional investors - are not on top of the risks. They have a view that passive investments are commodity items and that it just not the case,” he says.
“If a counterparty goes bust, investors will find that instead of being invested in a European equity tracker, they are invested in European government debt. It is a rare event, but it could be catastrophic.”
Mairs says that investors need to do their research, or find someone who will do it for them. He says that no one ETF provider stands out as being better than any other and both swap-based and physical ETFs have their place.
He is also worried it may become more of a problem as ETF providers launch ever more esoteric strategies. The ETF market has seen the emergence of products offering geared returns, short exposure and ’active’ strategies. Mairs says that the mechanics of these funds are often complex and require research. In America, approval of several funds has been suspended by the Securities and Exchange Commission pending an examination of the underlying derivative structures.
The risks of ETFs may also become a greater concern as the Retail Distribution Review looms and more advisers contemplate a passive strategy for client assets. Also, independent advisers will have to demonstrate they can advise on all assets including ETFs, which will include an understanding of the risks involved. There is a danger that some of the mistakes associated with structured products are repeated for ETFs.
There is a temptation after every crisis to look for the next upset. Despite the controversies, it seems unlikely to be ETFs. However, there are risks in ETFs that are not understood by the market and ETF providers have admitted that there is an education gap. The concerns highlighted do not make them a no-go investment, but they do suggest that greater care is needed in their selection.
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