28 April 2011
Ben Gutteridge, Divisional Director – Brewin Dolphin Fund Research
The recent warning on ETFs from the Financial Stability Board has prompted a barrage of responses from City fund managers, with some even using the findings to leverage their own active management capabilities. At Brewin Dolphin, however, we are somewhat more sanguine about the concerns raised.
We certainly do not take any of the report’s conclusions lightly, however, based on the level of due diligence we have conducted upon the major ETF providers, within the UK, we do not believe that these vehicles pose a ‘systemic’ threat. The report raises the right questions in relation to construction and counterparty risk and will hopefully prompt potential investors to raise their own levels of research. It should also serve as a shot across the bow for providers to raise the standards of their operations. As said, however, having looked closely at the major providers within the UK, we believe perfectly reasonable processes are being undertaken. There is no guarantee of course, that smaller or new entrants are or will act in the same manner, and the same level of due diligence must always be undertaken.
In response to some of the other criticisms leveled at the industry, we would agree that there are some other less obvious issues to be considered when investing in ETFs. When looking at long only equity and bond strategies, we see very little risk emanating from their structure and would still consider them a cost efficient means of achieving asset class beta. Of course one needs to be careful not to take on too much credit exposure, but usually these funds will physically hold the assets or are fully collateralized i.e. a ring fenced pool of liquid assets exists, equaling the value of the investment, that investors will have claims upon should the ETF counterparty default. While the quality of this collateral has been raised as a source of concern; we have observed that collateral is usually outsourced to a major 3rd party custodian bank removing any conflicts of interest (the ability to offload any suspect mortgage backed securities).
In relation to stock lending, this is an operation that takes place throughout the mutual fund industry. Again these positions are (from what we have seen) fully collateralized and much of the reward is paid back into the fund.
The key risks that we have identified in the ETF world are among those that either ‘short’ assets or invest in commodities. The risks here aren’t particularly toxic but, given their construction, can lead to sub optimal portfolio construction. Our concern is, despite the perfectly rational pricing of an ETF, investors will not have done the required level of research and, as such, the product may perform in a dramatically different fashion to that which they had expected. And when this occurs, risk management, used in portfolio construction, becomes flawed.
Looking first at ETFs that short, we have observed that most are based on daily closing prices. This means a 10% rise in one specific day, will lead to a 10% fall in your short ETF. If we carry this on for a 5 day pattern i.e. the FTSE rises 10% five days in a row, a £100 long investment would be worth approximately £161 (up 61%). Such is the mechanics of daily calculation, however, that a £100 investment in a short ETF will be worth £62 (down 38%). This imperfect hedge needs to be accounted for. It is also worth considering that the more volatile the referenced asset, the greater this imperfection risk becomes.
The other issue lies with commodities. People have regularly bought commodity funds or ETCs believing that their product will trade inline with spot price movements. Unfortunately this is not the case and, unless purchasing an ETF that holds the physical, investors are at the mercy of not only the spot price but interest rates and the ‘roll yield’ as well.
In order not to receive delivery of the underlying commodity, ETFs will sell the expiring futures contract and buy one with a longer maturity (normally the next expiry due to liquidity). This is not a like for like transaction however, as longer maturities are usually more expensive (due to storage and insurance costs). Each time a contract is rolled, therefore, an ETF will suffer. Using financial parlance, contango is a rising futures curve with a negative roll yield and backwardation is falling futures curve with a positive roll yield.
Using this strategy no purchase of the commodity is made, instead collateral is stored as margin to cover any movement in price of the futures contract. This collateral will be impacted by changes in interest rates, and therefore, so is your return.
These risks certainly need to be made more transparent by ETF providers, but we would not describe them as toxic.
For further information
Please contact:
Ben Gutteridge on 0845 213 3415 Divisional Director – Fund Research
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