Exchange Traded Funds and Exchange Traded Products have been in the news recently as a high profile court case involving synthetic ETF trading has emerged. Despite their promise of relatively low cost investment and suitability for long term investing, has the sector been tarnished by this bad publicity? Alexandre Houpert of ETF provider SG Lyxor looks at the recent concerns about ETFs and at how the sector is responding.

He also takes a broader look at the recent growth in use of ETFs and trends in the sector, focusing particularly on how Financial Planners are using ETFs. ETFs remain a popular part of many Financial Planners portfolio plans but how they should respond to recent developments and keep up with movement in the sector and developments in the wider world? This article provides some answers.

2011 was a challenging year for planners who had to fight hard to keep portfolios in the black. This quest for positive returns cemented two important realisations; costs really matter, and buying actively managed funds is no guarantee of beating the market.

For some Financial Planners this meant a shift towards portfolio efficiency and building low cost, diversified portfolios. This approach puts more emphasis on long term asset allocation, and achieving the return of the market, rather than trying to outperform it through sophisticated market timing or expert stock picking.

This approach is supported by the ‘Efficient Market Theory’, which suggests that beating the market is impossible because the price of a stock already includes the knowledge and expectation of any change in its risk/return characteristics. The Capital Asset Pricing Model adds to this that because markets are efficient, a cap-weighted index, which weights exposure towards the biggest stocks, is naturally organised to provide the best return for a given market.

We are not here to argue whether these theories are correct, but for those that believe they are, tracking an index as efficiently as possible is all they need to do in order to generate optimum returns. With ready access to everything from small cap stocks to industrial metals within a Ucits structure, and a typical Total Expense Ratio of between 0.15 per cent and 0.85 per cent, ETFs and ETPs can offer a compelling investment case against this backdrop. Clearly the theory has its followers as Assets Under Management in ETFS and ETPs grew by over 220 per cent between December 2006 and December 2011*. ETFs look set to benefit from the Retail Distribution Review as even in a consultation paper released back in June 2009, the FSA stated “these products should be considered when deciding which products are suitable for a retail client.”

Many planners aren’t waiting for RDR, and are already switching a portion of client portfolios away from actively managed funds and into ETFs as part of a long- term asset allocation strategy. This may be adding diversification to the core portfolio by adding country or asset class exposures, or it may be more tactical; focusing on a specific theme, sector or strategy as a satellite exposure. Due to the low costs of trading and liquidity of ETFs, some planners are even using them for short-term tactical investments to take advantage of a specific opportunity. There is limited data on the specific trading patterns of planners through the wrap platforms or execution-only brokers. However, we can look at the overall trends in Europe. Unlike previous years where investment trends and flows have been relatively broad based, 2011 saw investors focus on single country developed equity ETFs such as Germany, which accounted for close to 57 per cent of all inflows, and to a lesser extent the US, which represented around 12 per cent of inflows*. Outside of equities, gold-related ETPs and ETFs have unsurprisingly captured close to 26 per cent of all net asset inflows. Fixed income ETPs have seen over €2bn flow out of government bonds, and over €1bn flow into corporate bonds and high yield bonds.

The alternative is swap-based, or “synthetic” ETFs, which generate the performance of the index by purchasing a Total Return Swap from an investments bank, and a segregated basket of physical assets for collateral. Under the terms of the Total Return Swap, the Swap issuer, which in the case of Lyxor ETFs is Societe Generale, commits to pay the daily return of the ETF’s benchmark index to the ETF, including any dividends which may be due. In essence, this means that before taxes and replication costs, the performance received by the ETF is the same as the benchmark index. In return, the ETF pays the Swap counterparty the performance of its physical assets including any dividends, plus a fee.

The ETF industry encountered its first headwinds in 2011; yes, market volatility affected every type of investment, but the ETF industry experienced something different. Its rapid growth caught the attention of The European Securities & Markets Authority, the Financial Stability Board and other regulatory bodies in 2011. And while the regulators were considering their verdict, ETF issuers began a very open debate over the relative merits of physical and synthetic replication. Unfortunately, the process only muddied the waters around ETFs as a whole, and for the first time in years, ETF assets fell just over 2 per cent between December 2010 and December 2011. Issues such as counterparty risk, asset quality and securities lending were called into question, often out of context, and generally lacking the full picture. It’s worth looking at some of the key areas of concern and shedding light on what may be the real issues for planners. The way an ETF replicates its benchmark index is perhaps the most contentious point. The truth is that there are two different methods; both offering different benefits to investors. The important point is to know the difference, and to understand the risks that come with your choice. Physical ETFs replicate the benchmark index by purchasing the underlying stocks.

There are some instances such as certain Emerging Markets or commodity markets where it is difficult, or even impossible to purchase the underlying assets directly. In these cases, the Swap based structure is the only way to access these markets efficiently. There are also issues for physical replication when the benchmark index has a large number of underlying securities – for example, MSCI World where it would be extremely difficult to buy all the assets physically, and fund managers may have to operate a sampling strategy, where only the most liquid securities are purchased. This can expose the fund to tracking error as the basket of securities is not a full reflection of the benchmark index. In contrast, the Total Return Swap in a synthetic structure will provide the precise performance of the benchmark index before fees.

Generally the split between physical and swap- based ETFs is fairly even in Europe but in 2011 physical ETFs did make a little ground on the back of the press coverage.

Ucits regulation dictates that the Swap can never exceed 10 per cent of the fund’s assets. Put simply, this means that if the Swap counterparty failed, the loss to the ETF could not exceed 10 per cent.The biggest criticism of Swap-based ETFs is counterparty risk. If the issuer of the Swap contract cannot make payments due, the Swap can become worthless. However, there are a few important points to consider which have not necessarily been highlighted in recent debates;

The swap exposure can be negative. If the basket of assets held by the fund is worth more than the benchmark index, the swap counterparty is in credit, and if the swap issuer defaulted the fund would profit. In terms of daily counterparty risk targets: 10 per cent is a maximum level for Swap exposure, and issuers such as Lyxor, manage the ETF’s exposure to the Swap counterparty every day in an effort to keep it as close to zero as possible.

If the ETF is in profit, that is the benchmark index is worth more than the basket of physical assets, the ETF purchases more physical assets with the profit on the daily swap. The counterparty risk is zero because the ETF assets are worth the same as the benchmark index.

Segregated assets: Swap-based ETFs hold physical assets as collateral, and in the case of Lyxor, these are owned directly by the fund. If the Swap counterparty were to default, and no other eligible Swap counterparty could be found, the fund’s assets can be sold.

Securities lending: many physically replicated ETFs earn additional revenue by lending the fund’s assets to other financial institutions. There are no regulations controlling this activity, and a substantial portion of a fund’s Net Asset Value can be lent out at any time. The loans are generally covered by collateral, but the quality is unregulated. This practice is nothing new, but advisers need to understand how it is managed, and with who, as this can introduce uncapped levels of counterparty risk.

Physical ETFs obviously aim to invest in the actual stocks which make up the underlying index. Swap-based ETFs however have been criticised because the physical assets can be completely uncorrelated to the benchmark index. This is true, but bear in mind that these physical assets have absolutely no impact on the performance of the ETF. They are just there to provide security to the fund and the swap agreement. This means that regardless of how remote the investment opportunity, swap-based ETFs can maintain strict guidelines over what goes in the ETF basket. Lyxor for example only uses Ucits eligible, large-cap stocks as collateral.

This means that if the Swap counterparty defaulted, and it was necessary to sell fund assets, it should be possible in one or two trading days in most cases – far from the horror stories of being stuck in untradeable junk bonds!

Transparency has been the word of the ETF revolution, and many issuers are making marked improvements in their disclosure of counterparty risks and fund assets. Lyxor for example publishes details of the Swap counterparty, the counterparty risk level and the physical fund holdings of every Lyxor ETF on their website every day. In 2012 the regulatory environment is likely to stabilise and this will encourage further adoption of ETFs. As long as markets remain relatively positive with less extreme volatility, Lyxor believes that the ETF and ETP market in Europe can grow by around 15 per cent to €260bn by year end.