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Exchange mechanism

Concerns about the structure of ETFs are mounting, reports Joanne Ellul, and tighter regulation of synthetic funds looks likely under EC pressure

Exchange traded funds were thrust into the spotlight once again this month after a rogue UBS trader was charged with unauthorised trading and an ex-Goldman Sachs trader and his father were charged with insider trading on ETFs.

Earlier this month, UBS incurred £1.5bn of losses, allegedly through unauthorised trading conducted by Kweku Adoboli in its global synthetic equity business.

Speaking at the FSA’s asset management conference in London last week, European Commission head of asset management Tilman Lueder warned of the dangers of synthetic ETFs and hinted that Ucits rules may be changed to deal with EC concerns.

He said: “If the industry is using Ucits as a shield of defence, it is the regulator’s prerogative to see that the Ucits rules are changed. We are not relaxed about ETFs, especially synthetic ETFs.”

Also speaking at the conference, FSA conduct business unit director of policy Sheila Nicoll said: “ETFs are a European issue and need to be dealt with on a pan-European level. We will play our part in that process.”

A host of other regulators have recently expressed similar concerns about the ETF sector. In July, the Serious Fraud Office launched a review into how the funds are marketed. In April, the Financial Stability Board expressed concerns about the rapid growth and increasing complexity of the ETF market.

However, it is important to distinguish between the different ETF structures available to investors.

Physical ETFs hold a basket of stocks that replicate a chosen index as closely as possible. The basket is divided into units that are traded on the stock exchange.

Swap-based, or synthetic, ETFs work by holding a basket of stocks that may not be related to the basket of stocks which makes up the chosen index. The provider enters into an agreement with a counterparty so that if the basket of stocks underperforms the index, the counterparty must make up the difference to allow the ETF to continue tracking the index.

If the basket of stocks outperforms the index, the difference is paid to the counterparty.

Morningstar director of European ETF research Ben Johnson says the key risk to synthetic ETFs is if the counterparty defaults on its obligation to provide the return on the index.

He says: “Those counterparties with sturdier balance sheets and superior credit ratings are more desirable. Investors and IFAs should look at what collateral levels are, so what percentage of the fund’s assets are backed by either collateral or fully held fund assets, how often those collateral levels are topped up and what the composition of that collateral is.”

He says preference should be given to more liquid, high-quality collateral that is either equal to or greater than the fund’s net asset value and that is topped up on a regular basis.

Johnson gives the example of Credit Suisse, which tops up its funds’ collateral to 100 per cent of the net asset value at the end of each trading day.

Hargreaves Lansdown investment manager Ben Yearsley says swap-based ETFs are cheaper and tend to track the index more closely than physical ETFs but the trade-off is counterparty and collateral risk.

Yearsley says one of the criticisms directed at swap-based ETFs is that the basket of stocks, the collateral risk, may be very different to the indices investors expect to buy into. An example he gives is a Vietnamese ETF that invests in FTSE 100 companies.

He says: “It might look a bit odd to an investor who is not accustomed to buying ETFs but it is not a concern as long as the collateral the investment is backed by is good, like a FTSE 100 company.”

Seven Investment Management director Justin Urquhart Stewart says swap-based ETFs make it easier to replicate a broad index.

Urquhart Stewart says: “If you look at the emerging markets MSCI index, you could not fully replicate that physically, because countries are in different time zones and there is a large amount of stock. Therefore, you have to do sampling, which will not fully replicate the index. It is easier and cheaper to use a synthetic ETF, as long as you use the right provider.”

Urquhart Stewart says IFAs should consider a number of issues when considering swap-based ETF providers.

He says: “IFAs should look at the strength of the counterparty and the name involved in terms of the strength of their balance sheet and reputation, the process the provider uses, how experienced it is and the people involved.”

HSBC head of ETFs Farley Thomas says tighter regulation of synthetic ETFs is inevitable.

He says: “Banning synthetic ETFs from being marketed to retail investors is an extreme position but is possibly warranted. You could label the products as synthetic but disclosure does not help investors if the products are inherently incomprehensible. I would bet most investors do not understand how synthetic ETFs work, even if you label it as swap-based.”


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