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.
