There can be no doubting the popularity of ETFs. As an asset class it has grown substantially in recent years. According to data in BlackRock’s ETF Landscape Industry Review for end of Q1 this year the number of global ETFs has risen from around 1,200 in 2007 to 2,500 in 2010.
However, in recent months voices of concern have been getting louder, perhaps reaching a crescendo recently when a rogue trader was exposed at UBS. Estimated bank losses were USD2.3billion. Whilst the losses weren’t specifically linked to ETFs it is believed the trader created fictitious forward-selling, cash ETF positions. The trader worked on what banks refer to as a Delta 1 desk which trades in synthetic products.
It’s precisely the use of synthetic ETFs, the counterparty risks involved and the potential systemic risks they pose if counterparties receiving the swap payments invest in illiquid assets that has gotten people worried. But Eleanor Hope-Bell (pictured), head of intermediaries UK and Nordics at State Street Global Advisors is not surprised that lots of questions are being asked given the extent to which ETFs have become popular with retail and institutional investors alike.
“The questions being asked in Europe are different from those in the US where investors have had more time to become familiar with ETFs. The US market is well developed and understood,” says Hope-Bell.
She’s quick to add that ETFs do not, in her view, pose systemic risk although concedes that understanding middle- and back-office operations is sometimes overlooked. “In trade settlement you have to know what your counterparties are doing. A T+3 settlement is standard but T+5 might raise questions amongst counterparties. Anything beyond that would be highly unusual and in this instance was unique to UBS,” says Hope-Bell. Apparently, settlement dates running weeks into the future were used in the UBS case.
As said, ETFs per se were not responsible for the losses but what it has done is highlight loopholes in the way they’re traded. Namely, that London has liberal trade settlement rules and that many counterparties don’t automatically request trade confirmation. This is something that Paul Amery astutely pointed out in a blog on IndexUniverse.eu entitled “The ETF Loophole (almost) Everyone Missed” in September.
In the US, the Depositary Trust & Clearing Corporation (DTCC) reports regularly on failed settlements in ETFs and equities. This is something that Europe needs to do, and sooner rather than later. MiFID II will tighten things up for sure and improve transparency but that won’t be until 2013.
“There has been noise regarding trading. All ETF providers are trying to make that part of the investment process more transparent, like it is in the US. MiFID II is calling for more transparency and we think this would be a good development,” states Hope-Bell.
SPDR’s trading team in Europe observed recently that whilst most European institutional clients who had invested in synthetic ETFs had decided to rotate into physical ETFs, this was not due to bad press. “Synthetic ETF outflows appear to be more of a risk-off trade as opposed to any fears per se,” notes Hope-Bell.
Responding recently to negative headlines surrounding the safety of investing in ETFs at a panel discussion in London, Scott Ebner, global head of ETF product development at SPDR ETFs, said that accusations that ETFs destabilised markets were wrong: “The trading volumes of ETFs in Europe are still very small versus that of active investment. In reality, a couple of thousand ETF products are small compared to the number of funds in the Morningstar universe.”
That may be so, but a recent Skandia survey showed that 46 per cent of advisers hadn’t used ETFs for any clients – a sizeable percentage, suggesting that not everyone sees the merits of ETFs, despite the clear advantages of diversification they offer retail investors. Graham Bentley, Skandia’s investment expert said that it was synthetic rather ‘vanilla’ ETFs that were causing concern. “Given the rapid growth in ETFs and the counterparty risk involved, it’s not surprising that the regulatory bodies are heavily scrutinising the ETF market,” Bentley was quoted as saying.
Nevertheless, synthetic ETFs remain the sole preserve of institutions. These instruments account for 45 per cent of ETF assets under management. They are, in Hope-Bell’s opinion, very much a benefit to the industry.
“SPDR ETFs is a provider of physical ETFs only, though we understand there are limitations in terms of access with physical replication. Synthetic ETFs can take you into markets that aren’t available to physical ETFs,” says Hope-Bell.
Stephen Doran, fund manager, HSBC Global Asset Management, was quoted recently saying: “Synthetic ETFs are just not suitable for retail investors. There are due diligence requirements that preclude them from retail investors, but which institutions can do.”
Hope-Bell agrees: “Some institutions are comfortable with synthetics; they do their homework and understand the risks. Most have a preference for physical ETFs but if there’s an opportunity that gives them access to a market (e.g. local China) that physical ETFs can’t provide they’re often happy to invest in synthetics.”
The issue with ETFs seems to be one of education. Although these funds only make up around five per cent of total AUM in the UCITS market and don’t have as long a track record as mutual fund UCITS, no ETF has yet failed. “From a provider’s perspective we need to continue to educate investors, not just about ETFs but all financial products. I think that’s a huge positive for the whole industry,” says Hope-Bell.
She adds: “There’s a long way to go still in terms of educating on the key tenets of ETFs (low cost, transparency, liquidity) but investors are saying they will increase their allocations over the next one to three years.”
The introduction of the Retail Distribution Review in the UK on January 1st 2013 is likely to act as a further catalyst to growth. It will remove commission bias. Rather, advisory fees based on the portfolio will become the key compensation driver for intermediaries. This is likely to reduce costs and ultimately benefit end investors.
One of SSGA’s most successful products is the SPDR S&P US Dividend Aristocrats ETF. Since its European launch on 17 October 2011 the fund has raised USD277million: it reached USD100million within just 10 days of trading and is the firm’s fastest growing ETF. It tracks the S&P High Yield Dividend Aristocrats Index and has a portfolio of 60 US stocks from the S&P Composite 1500 Index that have paid an increased dividend, every year, for the last 25 years.
“Our clients are looking for high-dividend yield products. We continue to see large flows into the SPDR S&P US Dividend Aristocrats fund, which is one of the best-selling ETFs launched this year. We also launched an emerging market dividend fund at the same time – SPDR S&P Emerging Markets Dividend ETF,” explains Hope-Bell.
This particular fund tracks the S&P Emerging Markets Dividend Opportunities Index and consists of around 100 high dividend-yielding liquid stocks from 20 emerging market countries with stable three-year growth. It yields 7.2 per cent and is the first and only EM dividend ETF domiciled in Europe.
As for where the next trend in ETFs may derive from, Hope-Bell cites Fixed Income as an underdeveloped market.
“If a product provider doesn’t offer access to a particular market segment there’s often a good reason for that: is it cost-effective, is it liquid? The majority of ETFs still mostly replicate equity markets but the fixed income space could be the next growth area.”
There are now 29 SPDR ETFs listed on European exchanges including Deutsche Borse, Euronext Paris, the London Stock Exchange, SIX Swiss Exchange and Borsa Italiana.