Morningstar
RecommendedSign Up to Our Newsletters Open Window IconMorningstar's Guide to Investing in Stocks Arrow Right
ETF Investing Ideas & News

Counterparty Risk May Be Worth The Return

VIDEO: Morningstar's Scott Burns discusses how counterparty risk may not be as bad as it's cracked up to be

Alanna Petroff 25 May, 2012 | 2:58PM
Facebook Twitter LinkedIn
Font-Size

 

Related Articles
- The Benefits of Synthetic ETFs
- 3 Rules for Finding the Right ETF
- More than 50% of UK Investors Use ETFs

More from the Morningstar Investment Conference
- Investment Ideas 2012

Video Transcript
Alanna Petroff: Any time that you make an investment, you're going to take on some element of risk and risk was the main theme in Scott Burns' talk when he spoke at the Morningstar 2012 Investment Conference. Scott Burns is head of ETF, alternatives and closed-end fund research at Morningstar and he sat down with me to discuss risk and the different kinds of risks, so: investment risk and counterparty risk. Here is what he had to say.

Scott Burns: So, there is all kinds of risk and I think we've learned a lot of lessons about that. There is your investment risk and that's what I think everybody was very focused on prior to the financial crisis, right. That's whether or not your stock or bond will go up or down, right, whether it appreciate in price, that's investment risk.

But we also have counterparty risk, and I think that's something that we've taken for granted, that we really got our eyes opened to during the 2008-2009 credit crisis: on the other side of every investment, of every financial transaction, as a counterparty. Our faith in our system has been shook a little bit by what is the – are they going to make good on that bet on the other side? That if I buy a derivative from you and I need to cash it in, that you'll still be solvent and you'll still be able to make good on that. So, counterparty risk is something that's very much in focus. Again, risk is very simple; it's whether or not I'm going to get my money.

Petroff: So how does that relate to ETFs exactly?

Burns: Well, you know, ETFs have been in the headlines a lot for the counterparty risk aspect of what's going on, which I think it kind of really deviates away from the investment risk, which is probably much more core to the investing experience. But this counterparty risk has been taking a lot of headlines, a lot of sensationalism about whether or not when you're – if you're talking about synthetic ETF, whether or not the bank backing that swap will still be in existence and what kind of collateral there is behind it or on the physical ETF side, who are the people in a share lending process, who are those shares been lent to and are they good for returning that money? So, counterparty risk has definitely been top of mind in the ETF space.

Petroff: So if you are looking to invest in an ETF, should you just veer away from synthetic ETFs altogether or is there counterparty risk in everything?

Burns: Yeah. I mean, there is counterparty risk in everything and that's a big point of my talk today. You shouldn’t veer away from synthetic ETFs overall. I mean, you should understand what the risks are and you should understand that you are also being compensated for those risks, right.

That perfect tracking is important. Tracking error is a cost when you own an ETF. And then also sizing that risk, right. I think a lot of the sensationalism is created from the  view that if your backing bank goes under, you get nothing, right. So that you've got this bimodal experience of, I get my swap return until the day the bank goes under and then I get zero. 

Well, that's not true, because they have collateralised these. They are all UCITS funds, there are UCITS collateral requirements. So what really happens is if the bank, God forbid, goes under because we're talking about very large multinational banks here, that would not be good for anything. If they go under, what you would ultimately get is your collateral basket. So understanding what's in the collateral basket is important rather than just taking all this risk and throwing it out the window, because one of the ultimate maxims of finance is ‘risk must equal return’, right. So you're taking all this return and throwing it out the window.

So we want to be careful of that. Same thing with share lending in a physical ETF. We want to understand who those counterparties are, what their share lending practices are and what's the return back to the fund. I'll say it again, that's true for your UCITS mutual funds as well, to the extent that they're practicing share lending.

Petroff: That was Scott Burns. He is director of ETF closed-end fund and alternatives Research at Morningstar.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn
Font-Size

About Author

Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures

The Morningstar Star Rating for Stocks is assigned based on an analyst's estimate of a stocks fair value. It is projection/opinion and not a statement of fact. Morningstar assigns star ratings based on an analyst’s estimate of a stock's fair value. Four components drive the Star Rating: (1) our assessment of the firm’s economic moat, (2) our estimate of the stock’s fair value, (3) our uncertainty around that fair value estimate and (4) the current market price. This process culminates in a single-point star rating that is updated daily. A 5-star represents a belief that the stock is a good value at its current price; a 1-star stock isn't. If our base-case assumptions are true the market price will converge on our fair value estimate over time, generally within three years. Investments in securities are subject to market and other risks. Past performance of a security may or may not be sustained in future and is no indication of future performance. For detail information about the Morningstar Star Rating for Stocks, please visit here

Quantitative Fair Value Estimate represents Morningstar’s estimate of the per share dollar amount that a company’s equity is worth today. The Quantitative Fair Value Estimate is based on a statistical model derived from the Fair Value Estimate Morningstar’s equity analysts assign to companies which includes a financial forecast of the company. The Quantitative Fair Value Estimate is calculated daily. It is a projection/opinion and not a statement of fact. Investments in securities are subject to market and other risks. Past performance of a security may or may not be sustained in future and is no indication of future performance. For detail information about the Quantiative Fair Value Estimate, please visit here

The Morningstar Medalist Rating is the summary expression of Morningstar’s forward-looking analysis of investment strategies as offered via specific vehicles using a rating scale of Gold, Silver, Bronze, Neutral, and Negative. The Medalist Ratings indicate which investments Morningstar believes are likely to outperform a relevant index or peer group average on a risk-adjusted basis over time. Investment products are evaluated on three key pillars (People, Parent, and Process) which, when coupled with a fee assessment, forms the basis for Morningstar’s conviction in those products’ investment merits and determines the Medalist Rating they’re assigned. Pillar ratings take the form of Low, Below Average, Average, Above Average, and High. Pillars may be evaluated via an analyst’s qualitative assessment (either directly to a vehicle the analyst covers or indirectly when the pillar ratings of a covered vehicle are mapped to a related uncovered vehicle) or using algorithmic techniques. Vehicles are sorted by their expected performance into rating groups defined by their Morningstar Category and their active or passive status. When analysts directly cover a vehicle, they assign the three pillar ratings based on their qualitative assessment, subject to the oversight of the Analyst Rating Committee, and monitor and reevaluate them at least every 14 months. When the vehicles are covered either indirectly by analysts or by algorithm, the ratings are assigned monthly. For more detailed information about these ratings, including their methodology, please go to here

The Morningstar Medalist Ratings are not statements of fact, nor are they credit or risk ratings. The Morningstar Medalist Rating (i) should not be used as the sole basis in evaluating an investment product, (ii) involves unknown risks and uncertainties which may cause expectations not to occur or to differ significantly from what was expected, (iii) are not guaranteed to be based on complete or accurate assumptions or models when determined algorithmically, (iv) involve the risk that the return target will not be met due to such things as unforeseen changes in changes in management, technology, economic development, interest rate development, operating and/or material costs, competitive pressure, supervisory law, exchange rate, tax rates, exchange rate changes, and/or changes in political and social conditions, and (v) should not be considered an offer or solicitation to buy or sell the investment product. A change in the fundamental factors underlying the Morningstar Medalist Rating can mean that the rating is subsequently no longer accurate.

For information on the historical Morningstar Medalist Rating for any managed investment Morningstar covers, please contact your local Morningstar office.

For more detailed information about conflicts of interest, including EU MAR disclosures, please see the “Morningstar Medalist Rating Analyst Conflict of Interest & Other Disclosures for EMEA”here

Select Your Site Edition To make sure the site is relevant to you, we need to know if you’re an individual investor or a financial professional.