Excellent Article on risk of ETFs

Ban swap-based ETFs, says ex-chief of Eurizon

By Chris Newlands

Published: November 1 2009 09:14 | Last updated: November 1 2009 09:14

Swap-based exchange traded funds that target retail investors should be banned, according to former Eurizon chief executive Francis Candylaftis.

Mr Candylaftis, whose departure from Italy’s Eurizon was announced last month, believes European regulators should outlaw synthetically structured ETFs that track an index. He says they do not comply with the transparency rules or expectations Ucits vehicles claim to have. Providers, he says, should instead buy the physical assets.
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“The growth of ETFs in Europe is based on the myth that ETFs are transparent whereas most ETFs in Europe – with the exception of Barclays’ – are swap-based, something completely unknown to investors,” says the former head of Italy’s largest asset manager.

According to Manooj Mistry, UK head of db x-trackers, more than 50 per cent of ETF assets under management are held in synthetically-replicated index products – a trend db x-trackers is unconcerned by. Most new providers, he adds, now only adopt this structure.

This, however, angers Mr Candylaftis. “I do not understand the distinction between structured products and ETFs. Most of the time ETFs are indeed structured products that should not have Ucits status,” he says.

“ETFs are okay for institutional investors who are supposedly aware of all these features and can evaluate them, but they are much less suitable for retail clients.”

Mr Candylaftis wants European regulators to either ban ETFs that use swaps or strictly enforce the 10 per cent counterparty-risk rule.

“It is a paradox that ETFs are meant to be very transparent instruments compared to traditional funds when, in fact, they are the opposite,” he says, adding that he wants retail-focused providers that replicate an index to actually buy the physical stocks instead of using the swap markets.

Mr Mistry, whose firm only promotes synthetically-replicated index products, disagrees. “All ETFs in Europe comply with Ucits III regulations, whether they are swap-based or not,” he says. “The question really should be which method – traditional or synthetic – works and performs best for investors, and we think that is swap-based products.”

Proponents of fully synthetic replication say it offers the advantage of being able to replicate pretty much any asset class exposure. Some areas, such as various domestic emerging debt markets, are difficult to access using physical replication because of tax disadvantages that can exist for overseas investors.

Swap-based tracking also removes the settlement and tracking error risk from investors and passes them on to a third party on the date a trade is made. When working with a liquid benchmark index and a well-tested settlement system like the DTCC in the US these concerns may seem minor, but in less developed markets this can offer real benefits to investors, experts say.

Axel Lomholt, head of product development for iShares Europe, which leans heavily towards traditional replication, says he understands these advantages but adds that his firm will always purchase the physical stocks when it can.

“Our first approach is to always try and buy the underlying assets,” he says. “It’s not always easy but you’d be surprised how far you can go with that route.

“Others will tell you it is too difficult or too expensive to buy the physical stocks but a lot of exposures can be replicated traditionally if you have the platform and the scale to do so – and we have.”

He adds: “Clients prefer ETFs that are backed by the physical assets. Research shows this to be true and that is why we go down that route when we can.”

Mr Lomholt, however, does not go so far as to agree with Mr Candylaftis that swap-based ETFs should be outlawed from the retail market. “They are an extremely useful tool,” he says. “We don’t overly rely on them like some houses because of the counterparty risk that exists but I don’t agree that swaps should be banned from the world of ETFs.”

Under European Ucits rules any counterparty exposure is limited to 10 per cent of a fund’s net asset value but, in practice, many ETF issuers manage this exposure to a lower maximum percentage of 0-5 per cent.

Nevertheless, fears over possible bank failures, stemming from the Lehman collapse last year, were sufficient to drive many investors away from swap-based ETFs in favour of the more traditional ETF structure in which the fund owns all or a representative sample of the securities in the index.

“This was a big topic when Lehman collapsed, and rightly so,” says Mr Mistry. “But we fully collateralise the majority of our funds and over-collateralise on all our equity, commodity and hedge fund ETFs. We do this to remove any fears investors might have regarding counterparty risk.

“Almost 50 per cent of ETFs are fully synthetic and so it’s not true to say people now don’t want these products.”

All iShares’ fixed income ETFs use traditional index replication but Mr Lomholt concedes Mr Mistry’s point: “Counterparty risk has been a worry since the Lehman collapse but the ETF market has not itself experienced a problem up until now, even though we have been through some extreme times. That’s important to remember.”