As the financial regulation debate goes on across the world, the Exchange-Traded-Product industry continues to feel it has been unfairly singled out – even universally blamed – for issues that are really applicable to the mutual fund universe. At the last Morningstar US ETF Invest conference held in Chicago in September, Don Phillips, Global Head of Fund Research at Morningstar, accurately captured the shift in general perceptions vis-à-vis the ETP industry when he said that “ETFs have become the bogeyman for anything complicated or challenging to understand”.
Voicing concerns about what could amount to unfair treatment against the ETP industry does certainly not excuse the need for fair criticism. In fact, we at Morningstar have been very critical at times with the way the ETP industry was developing – particularly in Europe – and have repeatedly called for improved transparency on the operational methods and the sources of counterparty risk, both for physical and swap replicated ETPs. In that sense, it is comforting to note that the bulk of our recommended best practices, such as the regular disclosure of collateral baskets as well as of the details of securities lending programmes, have now been adopted by the majority of European ETP providers, even if this transparency push has come about as a self-defence move by an industry that has developed something of an “under siege” mentality.
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. The “D” word (i.e. derivative) is one that in today’s world conjures up all sorts of negative images. And so, in a way it is no surprise that regulators and legislators might feel inclined to show a firmer hand against the synthetic ETF side of the industry.
For example, suggestions that the new MiFID legislation might entail a classification of UCITS funds as “complex” and “non complex” depending on whether derivatives are embedded in the fund structure would be a negative development for swap-based ETP providers in Europe. It would call for a significant change in the way these products are marketed; perhaps even making them legally unsuitable for sale to retail investors. It is difficult to argue against the assumption that the common investor will always be more likely to understand the basic concept of physical replication much easily than that of synthetic replication. However, “easy to understand” should never be equated to “less risky”.
The message that swap replication could become something of an “endangered species” has not been helped by specific events, both in Europe (e.g. Credit Suisse changing the replication method of four of its 16 synthetic funds to physical) and worldwide (e.g. Australian ETF provider BetaShares changing the replication methodology of the only two swap-based ETFs marketed in the Australian market). Perhaps more importantly, as described in the article "The Truth about Synthetic vs. Physical ETP Flows", ETP fund flows data showed net outflows of the synthetic side of the ETP industry in Q3-11 and substantial inflows to physical replicated funds. A detailed analysis of the data revealed that “fear of synthetic” alone was probably not the only cause explaining these flows (e.g. not all synthetic ETP providers experienced net outflows), but as a whole the figures, not just for Q3-11 but for the January-September period, backed up the message of “migration from swap to physical”.
Sensing that the tide is in their favour, some of the key exponents of physical replication have renewed their attacks on the synthetic side of the industry. The uneasy truce between iShares and the synthetic providers in Europe, which, let’s remind ourselves, was only achieved as a result of iShares launching its own suite of swap-based ETFs a year ago, has now been effectively broken. And so we are back to the old battle lines, with iShares calling for anything swap-based not to be called an ETF and the synthetic providers highlighting that physical funds that engage in securities lending do carry a substantial level of counterparty risk for investors.
At this stage the discussions between regulators and the ETP industry are ongoing. It would be purely speculative to affirm that the final decision on how to classify ETPs – and thus the rules under which they will be marketed – will be made purely on the basis of replication methodology rather than on a more comprehensive approach taking into consideration the crucial issue of counterparty risk exposure. We at Morningstar believe the latter would be of greater service to the investor community.
This article was originally published November 2011.
