To say that the ETP industry is under heavy scrutiny around the world would be a massive understatement. Perceptions about the exchange-traded-product industry have changed dramatically over the past year. International economic bodies such as the IMF or the BIS have set their sights in the fast-growing ETP market, identifying it as a potential source of “systemic risk”. We know that much of the criticism so far laid against the ETP market is actually not ETP-specific, but applicable to the mutual fund industry in general. And yet, ETPs have become something of an easy target for the regulators, perhaps on account of being a fairly new industry posting punchy growth rates and thus gnawing market share away from the “old establishment”.
For some of the ETP providers, namely those following synthetic replication methods, the accusations of unfair treatment against the industry as a whole have been compounded by the feeling that they have been specifically targeted as the most likely sources of systemic risk. And so, one key question that we need to address is whether investors are responding to these concerns by actually migrating from swap to physical ETP structures.
What the Flows Tell Us
By looking at the market flows statistics out to end-Q3, one would be very tempted to argue that they are indeed. According to estimated net flows data sourced at Morningstar Direct, swap-replicated ETPs (note – for the purposes of this article we define ETP as the sum of ETFs and ETCs) experienced net outflows of close to EUR 2.1 billion in the third quarter of 2011, while physically-replicated ETPs saw net inflows worth EUR 5.74 billion. Looking at the historical data charted in the accompanying graph, one clearly notices that the third quarter stands out as the first since 2010 that one of the two replication methods has seen net outflows.
A more detailed analysis of net flows in the third quarter shows that 96% of money came out from synthetic ETPs, up from 51% in the second quarter of 2011. Meanwhile, 72% of net new money flowing into the ETP market was directed to physically-replicated funds, significantly up from 53% in Q2. In fact, the comparative analysis of fund flows between the first nine months of 2011 and the same period in 2010 shows similar dynamics. Given these figures it would be perhaps fair to argue that ETP investors may have been influenced in their decisions by concerns about the synthetic structures. After all, swap-replicated ETPs have lost market share through 2011 to their physical-replicated peers, with the trend accelerating during the summer months, as the accompanying graph shows.
Digging a Little Deeper
When analysing statistics it is important to fully strip out the data in order to fully validate the main message. When doing this we notice that not all the synthetic ETP providers behaved in the same fashion. In fact, the vast majority of the net outflows on the synthetic side of the industry in Q3 came from Lyxor funds, while for example db x-trackers--by now the second largest European provider in AUM terms--posted net inflows over the period. The reason is partly to do with general asset allocation flows, with db x-trackers benefiting from very substantial net inflows to a fund providing exposure to the German equity market (e.g. db x-trackers DAX). By contrast, Lyxor--not a strong contender when it comes to German equity exposure--saw substantial outflows from their suite of emerging market equity and eurozone government bond ETFs. The “DAX connection” is also found on the physically replicated side of the flows equation. According to our calculations, some 61% of the net new money flowing to iShares over the third quarter went to the iShares DAX. It is also worth considering that Lyxor outflows over Q3--in fact, throughout 2011--may have been partly related to concerns about the health of the French banking system in general and of Société Générale (GLE) in particular, of which Lyxor is a subsidiary.
Taken as whole, the evidence would support the notion of migration from synthetic to physical replication in 2011. And yet, it is important to stress that “fear of synthetic” alone may not be enough to explain the underlying market dynamics.
This article was originally published November 2011.
