The UBS rogue-trading debacle, which has fuelled calls for a clampdown on exchange traded funds (ETFs), came to light at a critical time for the $1,400bn (€1,026bn) ETF industry, as various regulators have been considering proposals to tighten rules governing the instruments, with an emphasis on the risks in synthetic replication.
Delta One trader Kweku Adoboli has been charged with fraud for the $2.3bn loss, the true magnitude of which, according to a UBS statement, was “distorted because the positions had been offset in our systems with fictitious, forward-settling, cash ETF positions, allegedly executed by the trader”.
However, even before there was any evidence of the nature of Mr Adoboli’s trades, ETF critics were having a field day. Terry Smith, chief executive of money brokers Tullett Prebon, a long-term ETF critic, asked: “What if such ETF trades cause such a mammoth loss in a counterparty which does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer – the ETF will fail.”
Mr Smith also argues that the ETF sector is deceptively profitable for providers owing to margins in the derivative trades, that ETFs do not always behave in the way investors expect, particularly leveraged and inverse funds which can move completely contrary to expections and that hedge funds buying ETFs to go short, are sometimes up to 1000 per cent short.
Ironically, in the weeks before the scandal came to light, the pro-ETF camp had made some progress in the PR battle by pointing out the hidden, unmonitored risks relating to collateral in other popular investments. In particular, some 50 per cent of mutual fund managers are taking similar risks with investors’ money by securities lending, according to research by SCM Private, a UK wealth manager that builds portfolios from ETFs.
“Current self-interested debate on the dangers of ETFs would seem about as fair and impartial as the Salem witch trials,” says Alan Miller, SCM Private’s founder.
“The debate over synthetic exchange funds has missed the point that numerous other retail products have similar risks, namely over 50 per cent of unit trusts, most structured products, the entire spread betting industry and most physical exchange funds. Some of the negatives that ETF bashers are bleating on about are far more prevalent in other products,” he explains.
“The FSA’s comments in June that synthetics ETFs might not be suitable for retail investors is pretty random when some of the same risks apply in mutual funds, particularly in absolute return funds, none of which declare the precise level of counterparty risk as ETFs do,” adds Mr Miller.
The European Securities and Markets Authority (Esma) has issued a consultation paper primarily looking at synthetic ETFs and counterparty risk, and invited comments by mid-September. It is also reviewing index-tracking issues, costs, the quality of collateral held, actively-managed and leveraged ETFs, and how certain ETF structures allow credit institutions to raise funding against relatively illiquid assets.
Many providers already meet Esma’s likely requirements, for example by using multiple counterparties and publishing the details of collateral. “ETFs are tightly regulated,” says Manooj Mistry, head of db x-trackers, UK.
“By meeting Ucits standards, and by having an independent custodian, asset manager and administrator in place, this ensures there are no conflicts of interest. db X-trackers was one of the first mutual fund providers to let investors access daily updated, fully granular data on the collateral on all of our products. The collateral backing our swap agreements is of high quality. Only blue-chip equities and minimum investment grade bonds from developed countries can be used, for example. Of the bonds used as collateral across our fixed income ETF range, around 70 per cent are triple-A rated.”
iShares, which offers just three synthetic funds covering the Indian and Russian markets and a commodities product, also points out that its exposure is over-collateralised with high grade liquid holdings, and it publishes details of the collateral details and relevant swap spreads on a daily basis.
“We’ve seen an increase in the demand for physically backed ETFs as investors are looking for straightforward exposure to an asset class, and it is very easy for advisers to explain exactly what the investor will be holding when they sell it to clients,” says Feargal Dempsey, head of product strategy at iShares.
Most of the excitement in ETF product development is around active managers. Pimco is making waves with plans to launch an ETF version of its Total Return Fund, the portfolio overseen by bond guru Bill Gross.
Many niche product offerings are becoming quite sophisticated. Funds based on, say, currency strategies, hedge funds or active funds may be a challenge for the retail investor to understand, but leveraged and volatility funds may be nigh impossible for the layman to evaluate.
