May. 13, 2011
This analysis looks at the future regulatory treatment of European-domiciled ETFs, particularly in the light of the concerns about them highlighted in the Financial Stability Board’s (FSB) report that MyPrivateBanking's ETF expert Francis Groves looked at previously.
A good starting point to look at the issues that are being thrown up is an interesting and challenging article by Gillian Tett (author of the book Fool's Gold) that appeared in FT.com exactly a week ago. Entitled “Why ETFs give an uneasy sense of déjà vu”, the article’s main points are that ETFs are becoming increasingly popular with ‘retail’ investors, that ETF structures are becoming more complex and that ETF popularity could be nurturing hidden risks to the financial system on a par with the collateralised debt obligation risks that ballooned between 2005 and 2008.
In some respects this picture of the state of ETFs seems over-simplified and, naturally, I hope this dire warning doesn’t prove to be accurate. Retail investor use of ETFs and ETCs in Europe hasn’t been so impressive up until now. Of course, that might easily change, but I’d also question the characterisation of ETF development as being a case of increasing creativity and sophistication in the way in which they are structured. The European development of swap-based replication was a giant step up in complexity in comparison to the North American in-kind replication model developed in the Nineties. But swap-based ETFs have been around for years now.
True, leverage, inverse and active ETFs and ETCs tracking commodity futures indices are more complex than standard equity index tracker ETFs but at the same time as these have been in development, there are ETF sponsors like HSBC (and soon, hopefully, Vanguard) entering the European ETF market, who are trying hard to keep it simple. And at the same time some ETF sponsors such as iShares with their new swap-based ETFs and the sponsors who’ve adopted the so-called 3rd generation swap-based approach (the idea of reducing the risk of swap-based ETFs by using multiple swap counterparties instead of a single counterparty that’s another part of the very bank that is sponsoring the ETF) are genuinely trying to address some of the main criticisms made about swap-based complexity.
It seems that in reality there are two components to the danger of ETFs to private investors. Firstly, there’s the usual problem of investors moving into the ‘tricky’ end of the ETF spectrum without realising it; eg. leveraged ETFs, non-physically-backed ETCs and so on. This danger is always going to exist. I don’t know much about split capital investment trusts but I guess a fair number of investors invested in them thinking that they were no different from ordinary investment trusts. So ETF investors are well advised not to be greedy, not to be over-confident and to understand their investments rather than relying solely on what others tell them. This is the category A danger.
The second component of investors’ vulnerability is the part that derivatives play in the structure of swap-based ETFs. However, this dependence on derivatives is of a different order to the dangers to ETF investors getting out of their depth. This is risk to the financial system, a case of almost everyone losing a lot of money, not just you.
As far as private investors are concerned, the risks posed by the swaps in swap-based ETFs could be viewed as the hidden nine tenths of an iceberg below the surface of the sea. But, presumably, the regulators aren’t particularly worried about the danger this aspect of ETFs pose to private investors. Their main concern in relation to derivative risks of swap-based ETFs and private investors is that they might become hugely more popular (with retail investors) and increase the danger of some kind of systemic collapse. So this would really be a danger of investors to the financial system rather than the other way around. It would be neither completely fair nor transparent to lump this danger with category A dangers to make a combined rationale for making it more difficult for private investors to invest in ETFs.
And could private investors in ETFs be a danger to the financial system? There would need to be a lot more of them to begin with. Too much of anything can be dangerous but it would need some other factor – such as millions of private investors buying ETFs on margin – for the risk to become really serious.
It’s been argued that there could be a run on an ETF similar to a run on a bank. The argument is that ETFs are open-ended investments so the provider has to pay out cash if the holder of ETF shares wants them to be redeemed. However, for private investors, although ETFs open ended character is responsible for their effectiveness as trackers, in other respects they work like closed-end funds; smaller investors can only sell the shares, they can’t have them redeemed to order; that privilege is only open to institutions acting as authorised participants.
Even the dangers of institutions trading in ETFs may have been over-emphasised. It’s not as if the banks and others that sponsor swap-based ETFs are simply using their own shares as collateral. And, surely, for all the instances of the collateral basket being less liquid than the assets tracked by the ETF, there would be others where the collateral basket was made up of more liquid assets. That’s not to say that some widely accepted folly that allowed across the board, consistent mismatching of collateral and index could never arise but ETF sponsors and their swap counterparties don’t seem to be anywhere near there yet.
As Europe’s derivative’s market is huge, clearly of huge concern to financial regulators, and swap-based ETFs are tied into that market, it’s plain that there will be a story to tell. How well this is going to be explained by the regulators to the investing public is open to question.
Francis studied at the London School of Economics. He has many years of experience in the field of online business information, having worked for Reuters, the Financial Times and LexisNexis. He is the author of 'Corporate Actions, A Concise Guide' (2008) and the recently published 'Exchange Traded Funds, A Concise Guide to ETFs'. His blog is ETFSTall.