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Don't panic

Written by Peter Davy
October 2011

In the aftermath of the UBS loss, Peter Davy questions what impact it is set to
have on the perception of ETFs

If nothing else it was bad timing. In the immediate aftermath much was still unknown about the $2 billion loss made by UBS rogue trader Kweku Adoboli, but reports that it was on a trade related to an exchange traded fund (ETF) were ones the industry could have done without.

They follow warnings from almost every regulator one can think of. The Financial Stability Board (FSB), Bank of International Settlements (BIS), IMF and The European Securities and Markets Authority (ESMA) have all highlighted the risks in recent months at the international level. In the UK, the Bank of England, FSA and even the Serious Fraud Office have added cautionary voices of their own.

Nevertheless, providers insist the risks have been misrepresented or overblown. Adoboli hasn't made their case any easier to argue.

All in it together

It may, however, be true. Partly that's because the loss seems to be down to the actions of a rogue trader, and has little to do with the safety of ETFs.

As a spokesman at one leading provider puts it: "It's like asking whether there is an issue with equities trading because of Kerviel [former Societe Generale trader Jerome Kerviel, who lost £3.5 billion]. "In that particular instance it was one bad apple."

Others point to Nick Leeson, the man who broke Barings with futures. The point is the same: such risks are not peculiar to the financial instrument used. Or, as investment date provider Morningstar's director of European ETF research Ben Johnson put it in his response: "A bad trade was made - plain and simple."

Of course, that still leaves the concerns raised by regulators over recent months. However, here again, some dispute how worried investors should be.

For a start, some argue that reports have misrepresented the risks. We are, says Michael John Lytle, managing director at provider Source, in the midst of a three stage process: First regulators identify the potential risks; then consult with the industry and others to evaluate them; and finally decide which, if any, are genuine concerns requiring action. We are still on the second stage. Some of the reporting suggests it is the third.

"There has been a bit of an over reaction to the process of putting these issues on the table," Lytle argues.

Certainly it's true that the reports can tend to ignore the protections already in place. ETFs in Europe are, after all, Ucits funds, points out Brian Kelliher, partner at law firm Dillon Eustace in Dublin.

Consider the potential for conflicts of interest when the ETF provider and counterparty to an associated swap are part of the same group, for example - an issue highlighted by the BIS. The danger is that the investment bank is tempted to use illiquid assets already on
its books to collateralise ETFs. However, Ucits IV prevents that.

"The motives of the bank could be to fund some of the financial assets they are warehousing but they cannot be illiquid assets," says Kelliher. "It is just not possible under the rules."

There have been, perhaps, three principal dangers identified: worries over counterparty and collateral risks in synthetic ETFs; similar concerns over securities lending in physical products; and the danger of mis-selling due to poor understanding on the part of investors. None of these are new.

Take the concerns over synthetic ETFs, which use derivatives to replicate the performance of an index rather than investing in the assets that comprise it.

This debate came up with Ucits 10 years ago and clearly under Ucits regulators have been comfortable including derivatives within any kind of Ucits.

"People have raised concerns about ETFs using swaps to gain market exposure but it's pretty standard practice across large swathes of traditional funds," says Lytle. "Nobody has been concerned about investors who bought total return funds using derivatives."

The real issue, he adds, is not whether you use derivatives but how counterparty risks and transparency for clients are managed. And, in fact, it's much easier to provide ongoing information to investors on the fund when it is in the form of an ETF.

And it is not even a big market, relatively speaking, says Simon Klein, head of the Lyxor ETF business for Société Générale. Only two per cent of all equity risk is linked to synthetic ETFs, for example.

"The rest is in assets other than ETFs, such as swaps, equities, cash equities, equity derivatives and all kind of equity linked notes. They are 50 times the value of synthetic ETFs."

It's the reason he struggles to see the systemic risk in synthetic ETFs that some have talked about.

It's a similar story with securities lending. Look at the stock lending policy of Blackrock, the largest ETF manager through iShares, says Andrew Whiteley at passive investment specialist IFA Assetfirst; it's not restricted to ETFs.
"It is pretty much across their entire range of funds," he says. "In fact, it is inherent in most of the UK collective fund managers' ranges, not just their tracker products but across the full active funds as well."

Furthermore, none of this is news to institutional investors. The EDHEC-Risk Institute in France has surveyed institutional investors regularly over the last five years on ETFs. According to Dr Felix Goltz, its head of applied research, few will have been surprised by the issues the regulators have highlighted.

More questions ahead

It would be a mistake to think that the last few months haven't changed things, however.

For a start, it is not easy to ignore the UBS loss. And nor should investors be too comforted by the fact that UBS can stress no investors were affected, argues Terry Smith, chief executive of fund management business Fundsmith and inter-dealer money brokers Tullett Prebon - and a fierce critic of synthetic ETFs.

"UBS has the spare $2 billion to settle this," he points out. "Not every counterparty to every ETF trade can be guaranteed to be able to make that boast."

He also cautions against dismissing the regulatory concern too lightly, pointing out that it's "a relative rarity" for the IMF, Bank of International Settlements, Bank of England and the FSA to all raise questions over an investment vehicle. "It doesn't mean they are right, but it is fairly unusual."

At the International Centre for Financial Regulation, which promotes effective regulation of financial markets, meanwhile, head of research Dr Richard Reid says a sharper focus on ETFs is inevitable. "When you get a big incident it begs the question whether it's just an isolated case of poor risk management within an institution or something more."

In any case, there are, perhaps, already signs that investors' appetites are changing. Dan Draper, global head of ETFs for Credit Suisse, for instance, says the regulatory noises and consequent press have had an impact.

"The vast bulk of inflows this year were into physically replicated ETFs, so it is having an effect," he says.

But will the growth of the market overall slow? The providers reckon not. Disillusionment with active management, the opportunities for tactical asset allocation and a host of other factors will continue to drive growth - added to the fact that uptake among pension funds, for all it has grown, remains small in comparison to the passive funds market.

"ETFs make up only about five per cent of the market so there are significant opportunities for growth," says Manooj Mistry, head of db x-trackers in the UK at Deutsche Bank. “We are still only at the tip of the iceberg."

However, there's likely to be an added element of caution. Investors will be asking a lot more questions - and making sure they know exactly what's below the surface.

Written by Peter Davy



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