The strong growth of the Exchange-Traded Fund (ETF) market in Europe over the past years has resulted in an increasing level of scrutiny by regulators, research bodies and media commentators. This growing level of scrutiny has proved something of a double-edged sword. On the plus side, it is an explicit acknowledgment that the notion of “passive investing” is gaining ground amongst investors. However, in many instances the ETF industry has been unfairly singled out for issues - mainly pertaining to risk - that do really affect the investment fund industry as a whole.
Whether active or passive, investing always means taking risks in the expectation of a reward. Reduced to their simplest expression we can identify two broad categories of risk, namely investment and structural. Investment risk relates to the market performance of the asset, while structural risk relates to the product used to invest in the asset. Investment risk is unavoidable, but taking on structural risk should be a matter of personal choice.
In Europe, the debate about structural risk in ETFs has always been entwined with that about replication methodology. There are two strands of ETFs in the European marketplace: physical ETFs, which replicate the index they track by physically holding all, or a representative sample, of the index constituents; and the so-called “synthetic” ETFs, which deliver the index performance via a swap contract.
Conceptually, it is much easier to explain what physical replication is. However, it would be a mistake to equate “easy to understand” with “posing less structural risk”. And yet, this is precisely what some do, citing the existence of swap counterparty risk in synthetic ETFs as unequivocal proof. However, counterparty risk can also exist in physical ETFs, provided they lend out the fund’s constituents. And the main providers of physical ETFs in Europe actually do.
Now, it is important to stress that counterparty risk (i.e. the risk that the other party in a financial contract fails to fulfil its obligations) is not privy to ETFs. It can also affect a multitude of other investment vehicles, including traditional mutual funds, which also engage in securities lending activities and/or use derivatives. Nevertheless, when it comes to ETFs, investors and their advisers must make sure to understand the nature of this structural risk. Equally, they must also be able to judge whether the protective measures in place against it, as well as the compensation for taking it, are adequate.
The Use of Swaps in Synthetic ETFs
Synthetic ETFs deliver the performance of the index they track via a swap contract. The ETF manager builds a so-called “substitute basket” – sometimes also called “collateral basket” – with a mix of assets that may or may not bear any relation to the index the ETF tracks, and then enters into a swap contract with a counterparty – normally an investment bank – whereby it exchanges the performance of such a basket for that of the index. For this reason, counterparty risk is intrinsic to their structure. This means that investors are irremediably exposed – at least theoretically – to the risk that the swap counterparty fails to deliver the performance of the index. While there may be multiple reasons why this may happen, the worst case scenario would be where the swap counterparty simply goes bust. Irrespective of the cause, the ETF investor would be left with the contents of the “substitute basket” as collateral.
It is generally accepted that investors in synthetic ETFs are compensated for taking on swap counterparty risk with the reward of comparatively lower management fees and more accurate tracking vis-á-vis ETFs employing physical replication techniques. But there is also a series of regulatory measures that providers of synthetic ETFs must comply with as a means of protecting investors against this counterparty risk. Under UCITS rules, for example, the net counterparty risk exposure of an investment fund (i.e. not just ETFs) to any single issuer via a derivative (e.g. swap) cannot exceed 10% of its NAV. In effect this means that 90% of the ETF must be collateralised.
In reality though, the majority of synthetic ETF providers either fully or over collateralise their swap exposure on a voluntary basis, thereby increasing the level of protection afforded to investors. Furthermore, parallel to the voluntary enhancement of collateral requirements, providers of synthetic ETFs have also made major improvements in the area of transparency. For example, online disclosure – mostly on a daily basis – of the composition of the “substitute baskets” has become the norm. This level of transparency helps investors in synthetic ETFs to properly assess risk.
Securities Lending in Physical ETFs
Securities lending is the process of loaning assets to a third party in exchange for a fee. Some, though not all, providers of physically replicated ETFs have securities lending programmes in place with the objective of generating revenues that might partially, or in some cases completely, offset management fees and other sources of index tracking difference. Counterparty risk in this context arises from the fact that the borrowers of these assets might not return them to the ETF manager.
It is important to underline that, unlike the use of swaps for synthetic ETFs, securities lending is not a necessary practice for physical ETFs to deliver the performance of the index they track. Rather, the aim of a securities lending programme is to improve the ETF’s tracking performance. As such, exposing investors to the counterparty risk arising from securities lending becomes a matter of choice by ETF providers. However, the choice of assuming such risk should ultimately lie with the investor. Hence the need for the utmost degree of transparency on the ETF providers’ side as to whether they engage in these practices, what protective measures are in place, and what benefits investors may draw.
The level of disclosure around securities lending practices by providers of physical ETFs has improved substantially over the past couple of years. Some may argue it is not yet optimal. However, compared to the secrecy surrounding these practices in the actively-managed mutual fund industry, ETF providers can be fairly described as an “open book”.
In terms of protective measures, it has become common practice for providers of physical ETFs that engage in securities lending to either fully or over collateralise the loans. It is also important to note that while there is no regulatory limit to the amount a fund can lend out, some ETF providers have voluntarily adopted maximum on-loan limits. Some also offer indemnification (i.e. insurance) against potential losses.
Meanwhile, on the issue of benefits, the guidelines published in July 2012 by the European Securities and Markets Authority (ESMA) establish that all revenues arising from securities lending practices, net of direct and indirect operational costs that must be explicitly disclosed on the prospectus, should be returned to the ETF.
Quality of Collateral is Key
Irrespective of whether one opts to invest in a synthetic ETF or in a physical ETF which engages in securities lending, the degree of protection against counterparty risk will ultimately be a measure of the available collateral. The quantitative aspect of the collateral is important, and one where “the more the better” is the overriding rule. However, in the event of counterparty default, the level of compensation won’t be solely determined by quantity, but by whether the collateral is of good enough quality to be liquidated fast and at a fair price. And yet, evaluating quality is not a straightforward task. If pushed, we would all be able to come up with a rough classification of assets on the basis of perceived theoretical security. Nonetheless, the ability to sell any asset, and the price at which it can be sold, will ultimately be determined by the market environment at the time of the transaction.
Some of the guidelines published by ESMA last year touched on the issue of collateral quality. Amongst others, factors such as high liquidity, high credit rating, transparent pricing, and sufficient diversification of collateral assets are key towards minimising the chances of a shortfall when liquidating collateral.
In any case, the complete elimination of risk does not seem possible. But then again, it is precisely the assumption of risk that distinguishes investors from savers. What should matter for investors assuming risk of any kind is to do so fully aware. And in that respect, ETFs have set high standards of transparency – certainly much higher than those applied by the actively-managed mutual fund industry – that allow investors to do just that.
This Morningstar article was first published in FTAdviser.
