Exchange Traded Funds: State of the Market, Regulation and Current Concerns

Transcription

1 Governance and Regulation of Financial Institutions Academic Year ECON-S528 Pr. Pierre Francotte Exchange Traded Funds: State of the Market, Regulation and Current Concerns Sébastien Evrard Vincent Daxbek Jason Vassaux

2 Executive Summary Introduction Definition of Exchange Trade Fund 1 a. Physical ETFs. 1 b. Synthetic ETFs State of the ETFs Market The Regulation of ETFs Pros & Concerns about ETFs 3 a. Advantages 3 b. Concerns c. Regulatory Point of View..5 Conclusion. 5 Bibliography.6 Annex.7

3 The last two decades have seen a rapid emergence of a new class of financial assets, exchange traded funds (ETFs). Nowadays, ETFs, that are mainly concentrated in the US and in Europe, represent assets of USD1.5 trillion 1. In this paper, we will explain what are ETFs and look at the state of the market for such funds through section one and two. Then section three will focus on the regulation that applies to ETFs. Finally section four will exhibit the advantages and disadvantages of ETFs and what they might imply in term of regulation. 1. Definition of ETFs Exchange-traded funds (ETFs) are structured like open-ended mutual funds that basically track an index and can be traded like a stock. Thereby ETFs bring together the advantages of index diversification and shares trading flexibility. ETFs are traded on exchanges via brokers like stocks, long and short positions can consequently be taken. The first ETF was created to provide an easy access to the S&P 500. That is, the SPDR fund - launched in 1993 by State Street Global Advisor- tracks the S&P 500 stock index. Two main types of ETFs can be distinguished; the first type, using a physical replication scheme, which means that the index is replicated by holding the physical assets- the securities themselves-was designed in the US while the second type -called synthetic ETF- using derivatives to replicate the index was developed in Europe. a. Physical Replication ETFs The structure of ETFs using physical replication allows authorized participants (AP) to buy a portfolio of securities on the markets that reproduces the index tracked by the ETF and to provide them to the fund namely the ETF sponsor 2. In exchange for the basket of securities, the authorized participant receives ETF shares called creation units usually 50,000 of it 3. This process takes place in the primary market. Then shares are traded in the secondary market, like any other stock and investors can trade the ETF shares via their brokers. Figure 1 Physical and Synthetic ETFs in Europe (in USD Billion) Source: BlackRock; Bloomberg b. Synthetic Replication ETFs Synthetic ETFs use derivatives instead of physical assets. An incentive to use synthetic ETFs might be that synthetic structures reduce costs for example when the index has a specific regional or sector focus that might be difficult and costly to replicate typically in emerging markets where assets may be quite illiquid. Synthetic ETFs might therefore minimize tracking errors 4. 1 BlackRock Report: ETFs Landscape, April See figure 3 in annex. 3 In practice, the exchange of creation units against securities between the sponsor and the authorized participant is realized through a custodian bank. Hence, a cash component is delivered to the custodian bank to cover various fees. 4 The tracking error is the difference between the ETF return and the index return. -1-

4 A broadly used synthetic ETF structure is the unfunded swap structure 5. Unlike the physical replication structure, this one allows the authorized participant to get creation units from the ETF sponsor in exchange for cash rather than for a portfolio of securities replicating the index. Furthermore, the ETF sponsor takes part in a total return swap with another financial institution named the swap counterparty. Under the first part of this transaction the sponsor receives the index return for a given nominal amount that is transferred in cash to the swap counterparty. Under the second part, the counterparty provides the sponsor with a basket of collateral assets that can differ from those constituting the ETF index. The ETF sponsor then transfers the total return of the collateral assets to the counterparty. 2. State of the ETFs Market In the end of 2010, around 130 ETF sponsors were supplying close to 2,500 ETFs traded all around the world 6. According to Blackrock data, six sponsors (ishares from BlackRock, State Street Global Advisors, Vanguard, Lyxor Asset management, db x-trackers and Power shares) own more than 80% of the ETF market share. Total ETF assets under management more than tripled between 2005 and 2010 rising from $410 billion to $1,310 billion (see graph). ETFs assets accounts for a small part of the global mutual fund industry that managed near $23 trillion of assets in In Europe, 80% of ETF assets are held by institutional investors while in the US the share of institutional investors is 50% equal to the part of assets held by retail investors 7. Figure 2 Global ETFs market by asset type (in USD Billion) Source: BlackRock; Bloomberg. 3. The Regulation of ETFs Exchange traded funds have massively gained in popularity for the last ten years. However, almost no specific regulatory measures were put in place in order to control activities of ETFs. Instead, ETFs have used fund structures already put in place in their respective regions in order to develop. In Europe, almost all ETFs have a structure in compliance with the UCITS III directives. To benefit from this label, ETFs have to respect strict rules. For example: - Reporting rules that enhance transparency and help investors to understand the risks they bear by investing in the ETF. - Diversification rules. For replicating index funds, no financial asset from the same originator accounting for more than 20% of the net asset value (exception up to 35%). 5 See figure 4 in annex. 6 BlackRock Report: ETFs Landscape, April This may be explained by a lower financial intermediation rate in the US. -2-

5 - UCITS ETFs may use derivatives in order to replicate the composition of an index. At the condition that the underlying is a UCITS eligible fund, a financial index, an interest rate or a forex rate/currency 8. - Global exposure rules. The exposure resulting from the use of derivatives is restricted to 100% of the net asset value of the fund. - Other derivative requirements. The OTC counterparty exposure is limited up to 10% for credit institution counterparties and 5% for other counterparties. And this exposure can be reduced by the counterparty providing collateral (fulfilling standards of liquidity, creditworthiness, etc) to a custodian bank. - Securities lending is allowed. Which implies that, investors (borrowers) can take short positions in the security and that the fund can reinvest the collateral (margin) provided by the borrower. In the United States, ETFs are mainly constituted as unit investment trusts (UIT), grantor trusts, regulated investment trust (RIC) and investment trusts. These entities are regulated under either the Securities Act of 1933 or the Investment Act of Under these acts, ETFs must for example respect minimum rules of disclosure. However unlike in the European Union, the US regulator has decided to limit the use of derivatives in ETFs up to 20% of the fund s net asset value. This explains the much greater growth of synthetic ETFs in Europe than in the US Pros & Concerns about ETFs a. Pros - Diversification and flexibility: it gives access to private investors to a diversified portfolio by acquiring a single ETF share. (Plain vanilla structure) - High liquidity through an extensive secondary market. - Low required capital: private investors can invest with small amounts of money. As low as USD25 can be enough to buy one ETF share. While for other funds, such as hedge funds the minimum capital required reaches USD at least. - Transparency: At any time, investors are able to know the composition of the portfolio held by the ETF. ETF shares are continuously valued during the trading day. This is not the case for mutual funds which are valued at the close of each trading day. - With synthetic ETFs; on the one hand the tracking error risk is reduced, but on the other hand the investors are more exposed to the counter-party risk of the swap provider. - ETFs in the United States are often said to be more tax advantageous in comparison with mutual funds. This arises because shares of mutual funds are redeemed by shareholders, so as soon as a mutual fund realizes a capital gain, these gains are taxable to all shareholders. While ETFs are not redeemed by shareholders, but instead traded on the 8 UCITS Commission Directive 2007/16/EC 9 Seekingalpha.com: The 4 Structures of ETFs. 10 BIS Working Papers No 343, April

6 secondary market and thus capital gains are taxed only when a shareholder sells its shares 11. b. Concerns about ETFs First of all, ETFs were basically simple instruments. But, with the growing demand for those financial instruments, the competition grew bigger and innovation took place. Innovation led to more complex ETF structures and raised new issues. 1 ) Synthetic ETFs; when the swap provider and the ETF promoter are the same entity (typically a bank): -Conflicts of interest & liquidity crunch: As market-makers, banks often have illiquid assets in their books which are hard to finance through repo market. Therefore, a Swap transaction with an ETF can be seen as an opportunity to finance those illiquid assets. The financing mechanism works by putting those assets as collateral in a swap transaction with an ETF, but the collateral basket doesn t have to match the original assets tracked by the index! At the end, the investors are the losers because they are backed by illiquid assets instead of liquid ones originally tracked by the ETF while allowing the bank to benefits of this mechanism (Conflict of interest). On the other hand, because the assets put as collateral may be illiquid, in case of large unexpected withdrawal of ETF investors, the ETF provider may face troubles to sell those illiquid assets in order to fulfill investors requirements to be reimbursed. The bank acting both as ETF provider and swap provider has therefore to face a trade-off between suspending the redemption process, or to get an unexpected shortfall of liquidities on its bank side (Liquidity crunch). In case of bankruptcy of the swap providing entity, assets put as collateral may be frozen by a bankruptcy administrator since a bank can play a dual-role. 2 ) Synthetic ETFs issues: -Low quality and liquidity of assets put as collateral & lack of transparency: In the previous point, the attention was put on the manner banks can use synthetic ETFs for their own interests. Here the point is to highlight the fact that in cases when ETFs are using swap transactions, investors are often backed by illiquid assets even if the bank isn t playing a dualrole. Furthermore, the basket of assets put as collateral can be changed on a daily basis (lack of transparency). Because of the swap transaction, the risk endured by investors is therefore changing from a tracking error risk to a counterparty risk. As we mentioned previously, the basket of assets put as collateral can be illiquid and hard to sell for the ETF provider when large investors unexpectedly decide to withdraw their stakes. Thus, investors can suffer from being backed by illiquid assets even if they invested in an ETF tracking a liquid index (counterparty risk). 11 CFA Level Program Curriculum, Volume 4, p305-4-

7 3 ) Physical ETFs issues; tracking error: -Tracking error problem: Synthetic ETF structures require the ETF to physically hold the assets tracked by the index. For an ETF tracking an exotic or a less liquid market index, for example the assets may be costlier to get because of a bigger bid/ask spread. And holding just a subsample of assets of the index tracked can lead to significant differences in returns in case of volatile market conditions. These issues create a difference in the NAV value and the ETF share, and can give rise to premiums/discounts when ETF shares are traded. This concept is referred as tracking error. It can be avoided by using synthetic ETFs, but the problem is not really avoided, but transferred to a counterparty risk c. Regulatory Point of View Because of those issues, and because there is only one name, ETF, for funds that may in fact pursue totally different strategies that have different implications for investors in terms of risk. Some players 12 in the market of ETFs have proposed further regulation measures in order to harmonize the ETF market and create a clear label for ETFs which would avoid the confusion caused for example that almost all ETFs in Europe are UCITS III compliant while this might not be the case in the US 13. For example: - Classification for ETF according to their activities. Because an unleveraged (no lending of securities) physical ETF tracking an index does not bear counterparty risk, contrary to an ETF composed of debt securities, they should not have the same name. Then, some could be called exchange traded note (ETN), exchange traded commodity (ETC), etc. Enabling investors to better assess the risks borne when holding an ETF. - Standards rules stating the quality of counterparties and their collaterals. In order to ensure investors that the best practices in this matter are followed. - Standards rules of disclosure in terms of cost. For example in matter of costs and fees, a total expense ratio standardized in the industry should help investors comparing funds. - Standard rule of disclosure in terms of assets hold and exposures. This point is necessary for investors to have a real idea of the risk linked with the ETF and assess whether or not the fund suits to his preferences. - Interdiction of ETF promoter and its swap provider from belonging to the same group. As a conclusion, we can say that the success in the market of ETFs is deserved. Indeed, ETFs have allowed investors to buy simple portfolios as well as complex financial products easily and cheaply and remain a powerful tool to achieve diversification. However, we think that on the one hand a light regulation with the aim to standardize exchange traded funds compliance around the world and increase their transparency might be useful and would benefit to every players in the market. And on the other hand a stronger regulation aiming at defining the authorized and unauthorized relationships between the ETF promoter and its swap provider could help to prevent future market disorders resulting from their collusion. 12 I.e., BlackRock, ETFs: A Call for Greater Transparency and Consistent Regulation. October

8 Bibliography HEHN Elizabeth Exchange Traded Funds: Structure, Regulation and Application of a New Fund Class. Springer, p. Financial Stability Board (2011): Potential Financial Stability Issues Arising from Recent Trends in Exchange Traded Funds (ETFs). BlackRock (2011): ETF Landscape, Industry Review, End Q BlackRock (2011): ETFs: A Call for Greater Transparency and Consistent Regulation, October London Stock Exchange (2009): Simple Product. Sophisticated Strategies. Exchange Traded Funds. Hong Kong Exchanges and Clearing (2010): Understanding Exchange Traded Funds. StateStreet (2009): Exchange Traded Fund: Maximizing the Opportunities for Institutional Investors. Vision Focus, Dec Bank for International Settlements (2011): Market Structures and Systemic Risks of Exchange Traded Funds. BIS Working Papers No 343. April PwC (2011): Being Distinctive, Exchange Traded Funds (ETFs), June CFA Institute Level : Volume 4, Corporate Finance and Portfolio Management. Pearson, p. -6-

9 Annex Figure 3. Operational Structure of ETFs Using Physical Replication. Source: BIS Figure 4. Unfunded Swap Structure. Source: BIS -7-