Now this is interesting. Former chief executive of Eurizon, Italy’s largest asset manager, Francis Candylaftis has launched something of an attack on European swap-based ETFs.
Candylaftis’ issue, he tells the FT on Monday, is that European ETFs’ tendency to be structured around swap-based models leaves them far from the transparent products they are being marketed as being to retail investors.
As the report states:
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.
“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.
One of the biggest providers of swap-based ETFs to the market in Europe is Deutsche Bank’s DB x-trackers, whose UK head Manooj Mistry — quoted defending the industry in the article — has previously made a point of getting in touch with FT Alphaville to explain that swap-based ETFs are in many ways better than conventional asset-owning exchange traded funds.
He told FT Alphaville that this was because a swap-based model makes for superior index tracking. While he acknowledged there was an issue with counter-party risk he said that this too was being exaggerated because the exposure lay entirely with just one well-reputed entity – Deutsche Bank. What’s more in Europe, he added, UCITs legislation requires that funds are at the very least 90 per cent collateralized, meaning that in the event of counterparty failure, the funds have 90 per cent collateral to fall back on.
(Update: 1544 GMT – DB x trackers got in touch to point out that in the case of DB funds ‘most’ are collaterilised beyond the 90 per cent limit, if not over collateralised.)
Here, meanwhile, are some graphics from DB x-trackers sent to FT Alphaville to illustrate their point.
First, how the funds outperform on tracking error:
And here’s how their structure compares to conventional ETFs, allowing them to achieve the above:
Although this sort of defence came as little comfort to Candylaftis who told the FT:
“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.You see, Candylaftis’ issue is with what happens in the red-button box of DB x-trackers’ own illustration and also in exactly how they collateralise the funds.
As DB x-trackers explained to FT Alphaville, the collateralisation centres on diversified UCITs compliant assets, which are transferable and listed on recognised exchanges. While they are ‘mostly comprised’ of OECD equities and investment grade bonds, they do not necessarily have to reflect the composition of the indices they are tracking.
Second, while Deutsche Bank’s hedging may mimic outright replication, it doesn’t have to. Deutsche can hedge its swap exposure any way it wants to. While its internal strategy may generate enhancements from stock lending and ‘dividend optimisation’ — as the red box states it attempts to– there is no way the investor can be sure of how much revenue Deutsche Bank is making here. Its strategy remains entirely proprietary, discretionary and opaque. What’s more, it can involve taking advantage of the bank’s unique position as a master authorised participant, which may or may not see it trading around arbitrage opportunities that conflict with the interests of its own ETF investors.
In other words, Deutsche Bank can use enhanced revenues to top-up short-falls in its index tracking when it suits it to, but does not have to pass-on any enhanced profits to ETF investors when it doesn’t. This means that as well as taking a transparent slice of the fund’s performance in fees, Deutsche may also be generating x amount of revenue for itself, the value of which can never be known to investors.
Furthermore, while Deutsche Bank will always be liable to come good on the total performance swap irrespective of its hedging success, the point is investors never know how their investments are being hedged at any given time. In that sense an investment in a DB x tracker swap-based ETF can be compared to an investment in Deutsche Bank’s own credit quality, rather than an underlying index.
That’s fair enough if you know what you’re getting into, but not if you don’t.
Related links:
The rise of synthetic ETFs – FT Alphaville
Statistical arbitrage and the big retail ETF con-fusion – FT Alphaville
The Hidden Risks of ETFs - Money Morning