Paul Amery, editor of IndexUniverse.eu, a specialist publication devoted to index-based investing and exchange-traded funds, considers the recent assault on the market.
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Last week’s three-pronged attack from the super-regulators of the world’s financial system — the G20 Financial Stability Board (FSB), the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) — has left the exchange-traded fund industry feeling battered, bruised and unloved.
But what’s all the fuss about?
The regulators’ central argument is that, in adding layers of complexity to what was originally a simple index-tracking product, the ETF industry is in danger not only of offering its investors a poor deal but, more worryingly, of creating broader systemic risks. Last week’s BIS paper on ETFs goes into particular detail on this topic.
The recent explosive growth of the ETF market parallels the similar growth rate in structured credit products during another period of low official interest rates (in 2002-03), the BIS points out. We all know how that turned out. Since the BIS was practically alone amongst global regulators in warning of the credit bubble ahead of the 2008 crash, its views carry particular weight.
However, the BIS’s comparison of last decade’s bubble in structured credit products with the recent growth of the ETF market seems tenuous. The explosive growth in securitisation and the CDO market depended on a collective suspension of judgement about credit risk by investors and, in particular, on the nefarious role of the credit rating agencies in allowing their standards to be debased.
While ETFs have been flavour of the month for a while and you could argue that investors have been overenthusiastic in granting them blanket acceptance, it’s hard to label the ETF concept itself as a kind of systematic fraud, in the way that an asset-backed CDO of 2006 vintage undoubtedly was.
Certainly, some ETF structures — leveraged funds that suffer from exponential decay, certain commodity trackers, for example — have given many investors a nasty surprise. That nasty surprise was inherent in the way the ETFs’ underlying index was designed, it’s important to add. Other trackers — gold ETFs, variants on equity indices or corporate bond ETFs — have done well for many investors by offering market access in a way that wasn’t available before.
It’s also debatable whether there ever was a golden age of plain vanilla ETFs, which were then superseded by all these nasty complex ones. Variations on exchange-traded fund design have followed each other thick and fast over the last two decades, with European structurers making full use during the last few years of the continent’s relatively liberal rules concerning the use of derivatives in funds. Two-thirds of Europe’s ETFs now use derivatives to track their indices.
The regulators’ interventions of the last week have thrown valuable light on some potential conflicts of interest that can arise in the management of ETF businesses: when the issuer is part of an investment bank, for example, or if securities lending is used to enhance returns. Investors will do well to assess ETF structures on the basis of some of the risk categories highlighted by the FSB and the BIS.
More broadly, though, one senses that there’s a fundamental disquiet amongst global regulators at the speed at which financial market transactions can now occur. Recent events — last year’s flash crash, for example, in which ETFs featured prominently — have demonstrated the potential for rapid, unpredictable contagion effects from one market to another. “The regulators would be happier if everyone went back to holding their investments in the form of non-tradeable insurance contracts,” one lawyer told me recently.
But history is proceeding at a very different pace. At last week’s TradeTech conference in London, participants spoke of round-the-clock tradeability in equities (and ETFs) as the future. For the time being, inefficiencies in the post-trade infrastructure make it difficult to trade in this way with a single point of settlement — but that’s the goal towards which many are heading.
If regulators are intent on stopping this trend towards greater speed and more seamless trading, then there’s a bigger clash coming. And while ETFs may be a trigger point for the debate, it’s important to look beyond what is still a relatively small sector of the fund industry. There’s a battle going on over the future infrastructure of the global financial markets.
Read more at IndexUniverse.eu