By Hilaire Gomer

It’s an irony that the US presented the exchange traded fund (ETF) to the world almost 20 years ago as a passive index tracker investment of, say, the S&P 500 and therefore low cost and, like equities, easy to trade and summarised as ‘transparent’.

But ETFs have a different image now. The UK’s Serious Fraud Office is watching ETF market and, in June, the UK’s Financial Policy Committee said it too was concerned that European banks have become too reliant on ETFs to finance themselves. Could ETFs create their own bonfire of the vanities?

ETF’s exponential growth - up 40 per cent in the last decade, and worth over US$300 billion (£186.8 billion) - has come thanks to innovation, sophistication and increasingly complex structures. Now
you can buy long, short, forward, leveraged ETFs and have access to every sort of commodity.

Wake up calls
In spring 2011, there were wake up calls for the industry from several critical studies of ETFs - the IMF, the US’s Greenwich Associates, The Bank of International Settlements and the UK’s Financial Stability Board (FSB). The latter found that recent innovation in ETFs was bringing “disquieting developments” and new elements of “complexity and opacity into the market”. It said there was a need for increased attention to ETFs by “providers, market-makers and investors”.

A recent survey, highlighting common investor complaints, summed up popular feeling: there were too many funds and they didn’t like the new unexplained and untested indices used by ETF providers.

The financial crash of 2008 helped kindle doubts when people realised some ETFs used leverage and the “dreaded derivative”. Another concern was that ETFs’ structure was becoming too complex and their increasing number and exotic types of investment (foreign exchange, clean energy, global water, bonds, timber) heightened regulators’ risk awareness.

Take short ET commodities, they are not straightforward because they provide ‘inverse exposure’ so investors earn a positive return when the index falls but will earn a negative return when the index rises.

The rise of the ‘swap’ exchange traded product is also regarded by some with misgiving. Because some commodities, like cotton, cannot be stored, the provider creates a synthetic index made from derivatives. The provider buys a swap which may “constitute a powerful source of contagion and systemic risk”, according to the FSB, because the moment there’s counterparty there is a danger of default - shades of shaky sovereign debt.

The ETF pioneer, ETF Securities, which holds US$27.5 billion worth of ETFs, issued a statement recently saying there wasn’t enough information about ETF collateral for investors and that collateral should not be used for the benefit of an ETF issuer where it might jeopardise the security of the collateral. ETF Securities’ web site now carries details of collateral for its foreign exchange ETFs.

Transparent issues
It isn’t surprising that when a new business like ETFs burgeons, the transparency has to dim a little. There are questions about ETF security lending and there has also been dissatisfaction about index tracking errors - some ETPs don’t match the index as closely as they should, affecting performance. This is thought to be due to the proliferation of ETPs where trading is less liquid, such as in futures contracts.

Farley Thomas, HSBC’s ETF chief comments: “Given that ETFs are listed on stock exchanges and can be accessed by anyone, the development of more complex ETFs has the potential to affect the industry adversely unless the issues are addressed properly through appropriate product communications and marketing.”

Axel Lomholt is IShares’s product developer in London and is calm about ETF criticism. IShares, now owned by Black Rock, is the world’s biggest ETP provider with 470 ETFs.

He says, “We welcome regulators’ interest in our products. It is vital that
our customers (about 80 per cent are institutions), which have benefited
hugely from ETFs and other vehicles like ET commodities, ET currency, understand how an ETF works.

“What some investors don’t realise is that there are now many different types of ETFs and with that goes differing risk. Take the classic tracker index ETF which dominates the market, it is UCits III-compliant which helps transparency. Swap ETFs are also UCits III-compliant. IShares has ETF swaps for Russian and Indian funds because the shares are hard to buy.”
Black Rock, in a response to the FSB, commented that under the Markets in Financial Instruments Directive (MiFID), ETF trade reporting is not usually required. To promote transparency, it wants the upcoming MiFID II to have all ETF trades reported.

The regulators are keeping a watch on ETF bonds and ETF commodities (usually held as a physical asset like gold or copper). They are fully collaterised and so carry counterparty risk. Synthetic ETNs or ‘notes’, a rarity so far but potentially troublesome, are structured products bought from a bank to cover commodities that can’t be stored, they are vulnerable to default too.

So, providers are on the defensive, they, like the regulators, want a product that won’t be prone to hazard or become merely a bet on a counterparty bank not going bust.

Even if there isn’t a financial meltdown triggered by exotic ETFs, with more proactive regulation some ETFs may prove insufficiently popular to trade and there could be a rationalisation of funds.

HSBC’s Thomas concludes: “Ultimately, simple, transparent, good value ETFs have the potential to continue growing rapidly while the more complex ETFs such as swap based ones may suffer stronger headwinds.”

ETF Securities’s ETF Short Cocoa
ETFS Short Cocoa (SCOC) is designed to provide investors
with a gross return of 100 per cent of the daily percentage change in the DJ-UBS Cocoa Sub-Index which tracks the futures price of cocoa plus a collateral yield.

- SCOC is an ETC structured as a secured, undated, limited recourse debt security which is redeemed on demand by market makers. It trades on exchanges just like an equity and its pricing and tracking operate similarly to an ETF.

- ‘ETC short’ is a cost efficient way of obtaining short (inverse) exposure.
Maximum loss is an investor’s initial investment.

- The ETC is backed by matching commodity contracts (fully funded swaps) with commodity contract counterparties whose payment obligations are backed by collateral. Collateral for SCOC is held in pledge accounts at Bank of New York Mellon.

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