ETFs - Past, Present, Future


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ETFs - Past, Present, Future

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  • Difficult to understand a firm like Morningstar proselytizing for ETF, particularly in Europe where most ETF are swap based (point admittedly made by Morningstar) hence assets actually held by the ETF are unknown to investors.
    Terms and conditions of the swap, foundation pillar, of the ETF are also most of time unknown to investors.
    Margin system put in place to satisfy counterparty limit with the swap counterparty does not cover overnight gap risk. Can and does the depositary bank exert its ucits function of controller of the assets of the fund over the operational process and monies of the margin account?

    ETF are not so economical for retail investors because in addition to the management fee which looks reasonable they also have to pay for the distribution under the form of the brokerage commission charged to buy ETF on stock exchange.

    ETF can apparently be economical because ETF sponsors and their related companies derive revenues from securities lending adding a risk which most of time is unsuspected by retail investors even if it is mentioned in the tiny letters of the prospectus.

    ETF have a ucits status whereas they often 'legally' violate the diversification rules imposed to the 'normal' ucits. They can do that thanks to the derivative built replication of indices which do not conform with the ucits diversification rules.

    From a systemic point of view, in strong up or specially down phases of the market when volatility is high and liquidity low, ETF add to the problem. They are pro-cyclical, even potentially creating IT systems breakdown, as suspected in the case of the US stock market two weeks ago. By definition they go in the same direction as the market, potential for very big tickets.

    As far as the large indices are concerned, ETF is a business for a happy few because volume attracts volume, because with big volumes come better prices. Down the road this concentration phenomenon potentially places an enormous power, from a corporate governance point of view, in the hands of very few major players who will end up with decisive ownership stakes in the largest companies in the world. What will they do with it? Passive managers have little incentive to fulfill their ucits manager fiduciary role. The bargaining power they will have in hand may even create situations of serious conflict of interest.

    ETF undoubtedly are a useful instrument for investors but they are not the panacea of the investment world as they are sometimes presented and despite appearances to the contrary they'd better remain an investment tool for institutional investors.
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  • ETFs - Past, Present, Future

    1. 1. ETFs: Past, Present, and Future Bradley Kay Associate Director, European ETF Research Ben Johnson ETF Strategist, European ETF Research March 25 th , 2010
    2. 2. Overview <ul><li>A Very Brief History </li></ul><ul><li>The ETF Marketplace Today </li></ul><ul><li>What Is An ETF? </li></ul><ul><li>What Advantages Do ETFs Offer? </li></ul><ul><li>Trends For The Future </li></ul>
    3. 3. Whence We Came: ETF Market Evolution
    4. 4. A Very Brief History <ul><li>1990 – The SEC issued the Investment Company Act Release No. 17809. This would ultimately facilitate the creation of mutual funds that were able to create and redeem shares intraday. </li></ul><ul><li>1993 – SPDRs S&P 500 begins trading on the AMEX in January. </li></ul><ul><li>1999 – The Tracker Fund of Hong Kong (TraHK) was launched in November, becoming the first ETF in Asia. </li></ul><ul><li>2000 – In April, the European Exchange Traded Fund Company launched a pair of listed diversified return securities (LDRS) on the Deutsche Borse. The funds, which tracked the EURO STOXX 50 and STOXX 50 indices were co-managed by Merrill Lynch. Later in the same month, iShares launched the first ETF in the UK, the iFTSE 100. </li></ul><ul><li>2003 – In February the first ETF on a fixed-income index in Europe was launched. The ETF eb.rexx Government Germany was issued by Indexchange and tracked the Eurex Bonds Government Germany index (eb.rexx). </li></ul><ul><li>2003 – ETF Securities launches the world’s first exchange-traded commodity Gold Bullion Securities in Australia and London. </li></ul>
    5. 5. European ETF Asset Growth by Broad Asset Category Source: Blackrock, Bloomberg
    6. 6. Where We Are Now
    7. 7. Proliferation of Asset Classes Category/Asset Class # of ETFs Total Net Assets As a % of Total Industry Assets Europe Equity 424 60,526,666,986 42.47 International Equity 243 32,723,777,179 22.96 Fixed Income 153 30,582,153,845 21.46 Traditional Asset Classes 820 £123,832,598,010 84.68 Commodity 291 16,982,675,211 11.92 Other 18 1,476,473,085 1.04 Currency 22 208,379,461 0.15 European ETF Industry Total 1151 £142,500,125,766 100.00 Morningstar Data as of Feb. 2010
    8. 8. Proliferation of Asset Classes <ul><li>In the beginning, ETFs only offered broad index and equity sector exposure </li></ul><ul><li>Now, ETFs offer access to nearly every asset category imaginable </li></ul><ul><ul><li>Fixed Income </li></ul></ul><ul><ul><li>Fundamental Indexes </li></ul></ul><ul><ul><li>Commodities </li></ul></ul><ul><ul><li>Currencies </li></ul></ul><ul><ul><li>Leveraged Equity </li></ul></ul><ul><ul><li>Hedge Fund Strategies </li></ul></ul><ul><ul><li>Niche Sector Slicing </li></ul></ul>
    9. 9. What Is An ETF? <ul><li>An umbrella term, covering a broad array of legal structures with a proliferation of abbreviations </li></ul><ul><ul><li>ETFs </li></ul></ul><ul><ul><li>ETCs </li></ul></ul><ul><li>Defining attributes </li></ul><ul><ul><li>Tracks a specific index or a strictly-defined portfolio of securities </li></ul></ul><ul><ul><ul><li>Almost exclusively passive investments </li></ul></ul></ul><ul><ul><li>Traded on a stock exchange </li></ul></ul><ul><ul><ul><li>A retail investment vehicle by nature </li></ul></ul></ul><ul><ul><li>Short-term arbitrage opportunity via daily or weekly share creations/redemptions </li></ul></ul><ul><ul><li>ETNs </li></ul></ul><ul><ul><li>ETPs </li></ul></ul>
    10. 10. What Is An ETF? <ul><li>Typically UCITS III compliant </li></ul><ul><ul><li>Diversified portfolios of securities: stocks, bonds, derivatives </li></ul></ul><ul><li>Physical-replication ETFs </li></ul><ul><ul><li>Match their index by holding the actual securities in a unique trust </li></ul></ul><ul><ul><li>Full or Sampled replication </li></ul></ul><ul><li>Synthetic-replication (or swap-based) ETFs </li></ul><ul><ul><li>Obtain their index exposure through OTC swap contracts </li></ul></ul><ul><ul><li>Hold securities in their own trust and/or have collateral pledged to mitigate counterparty risk </li></ul></ul>
    11. 11. What Is An ETC? <ul><li>Formerly “Exchange-Traded Commodity”, now also currency funds </li></ul><ul><li>Typically does not meet diversification standards for UCITS III </li></ul><ul><ul><li>Single commodity funds </li></ul></ul><ul><ul><li>Single currency funds </li></ul></ul><ul><li>Debt instruments issued by Special Purpose Vehicles (SPVs) </li></ul><ul><ul><li>Degree of counterparty risk varies widely </li></ul></ul><ul><li>European Union Prospectus Directive allows broad distribution </li></ul>
    12. 12. What Is An ETC? <ul><li>Physically-backed </li></ul><ul><ul><li>Only precious metals </li></ul></ul><ul><ul><li>Virtually zero counterparty risk </li></ul></ul><ul><li>Synthetic-replication </li></ul><ul><ul><li>SPV sometimes keeps the ETC’s capital, but usually given to total return swap (TRS) counterparty </li></ul></ul><ul><ul><li>Collateral may be allocated through a third-party custodian or simply pledged by the TRS counterparty </li></ul></ul><ul><ul><li>Acceptable securities for collateral can vary widely from provider to provider </li></ul></ul><ul><ul><li>Read Those Prospectuses! </li></ul></ul>
    13. 13. What Is An ETN? <ul><li>Exchange-Traded Note </li></ul><ul><li>Debt instrument issued by a backing bank </li></ul><ul><ul><li>Senior, unsecured debt of that bank </li></ul></ul><ul><ul><li>Substantial counterparty risk! </li></ul></ul><ul><li>Not a very popular vehicle in Europe, with only two issuers </li></ul><ul><ul><li>Lyxor pledges collateral for their ETNs </li></ul></ul><ul><ul><li>Barclays Capital issues uncollateralized ETNs </li></ul></ul><ul><li>Much more popular in the U.S., where they have substantial tax advantages for futures-dependent indices such as commodities </li></ul>
    14. 14. Innovation, You Say?
    15. 15. What’s So Great About ETFs? <ul><li>Incredibly low costs </li></ul><ul><li>Intra-day liquidity and real-time trading </li></ul><ul><li>Access to new asset classes and strategies </li></ul>ETFs bring the institutional to the individual
    16. 16. Low Costs <ul><li>Passive investments </li></ul><ul><ul><li>No expensive analysts </li></ul></ul><ul><ul><li>Typically low turnover </li></ul></ul><ul><li>Numerous back-office and mid-office efficiencies for providers </li></ul><ul><ul><li>Only need to issue and redeem shares with a limited number of market makers </li></ul></ul><ul><ul><li>Shifts portfolio trading costs to ultra-efficient market makers or swap counterparties </li></ul></ul><ul><li>Custodial costs have economies of scale due to cross-listings and broad distribution pulling in assets from across Europe </li></ul>
    17. 17. Intra-Day Liquidity and Real-Time Trading <ul><li>Real-time execution means that you know the price you are paying </li></ul><ul><li>Can provide more liquid exposure to illiquid asset classes </li></ul><ul><ul><li>When corporate bond markets froze in 2008/2009, credit bond ETFs kept trading </li></ul></ul><ul><li>Market makers arbitrage away premiums and discounts, keeping prices close to fair value </li></ul><ul><li>Warning: This shifts the onus of ensuring fair execution onto the final buyer rather than the provider </li></ul><ul><ul><li>Liquidity differs from fund to fund </li></ul></ul>
    18. 18. Access to New Asset Classes & Strategies <ul><li>Funds for in-house use with sophisticated clients are now easily offered to retail investors as well </li></ul><ul><ul><li>Physical precious metals </li></ul></ul><ul><ul><li>Asset allocation strategies </li></ul></ul><ul><ul><li>“ Alternative betas” </li></ul></ul><ul><li>ETFs serve as a wrapper for futures contracts that would otherwise have too high of a minimum size for retail investors </li></ul>
    19. 19. Where Do We Go From Here
    20. 20. Expansion of the Retail Market <ul><li>Everyone in the industry is waiting for the retail market to appear, but it will be harder than expected </li></ul><ul><li>Four major preconditions to a robust retail ETF market in Europe </li></ul><ul><ul><li>Increased retail investor demand </li></ul></ul><ul><ul><li>Greater trading volume / visible liquidity </li></ul></ul><ul><ul><li>Greater transparency </li></ul></ul><ul><ul><li>Simple cross-border transactions within EU </li></ul></ul>
    21. 21. Expansion of the Retail Market: Investor Demand <ul><li>Need to make the case to individual investors for low cost and passive investment </li></ul><ul><ul><li>Who will be the UK’s Jack Bogle? </li></ul></ul><ul><li>A critical mass of advisers and other financial professionals looking for low cost vehicles </li></ul><ul><ul><li>Organic movement toward fee-based financial advice took decades in the US </li></ul></ul><ul><ul><li>Regulatory pushes in Europe may accelerate the process </li></ul></ul><ul><ul><li>(UK’s Retail Distribution Review) </li></ul></ul>
    22. 22. Expansion of the Retail Market: Greater Trading Volume <ul><li>OTC trading volume does not do much for retail investors </li></ul><ul><li>Need to recruit a new sort of institutional investor, as heavy exchange traders and retail investors have a natural symbiosis in ETFs </li></ul><ul><ul><li>Make shorting ETFs easier </li></ul></ul><ul><ul><li>Movement toward ETFs as cheaper, easier, and more flexible than other forms of beta exposure (futures, swaps, etc.) </li></ul></ul><ul><li>Moving trade volume onto the exchanges is a self-perpetuating process once it starts, as greater liquidity makes larger on-exchange trades easier, which in turn generates more liquidity </li></ul>
    23. 23. Expansion of the Retail Market: Greater Transparency <ul><li>Apply MiFID to exchange-traded funds </li></ul><ul><ul><li>Reveal all liquidity to all market participants </li></ul></ul><ul><ul><li>Help retail investors feel comfortable that the playing field is level </li></ul></ul><ul><li>Retail investors want to know what they are holding </li></ul><ul><ul><li>Full portfolios published frequently and with little delay </li></ul></ul><ul><li>Synthetic replication ETF providers will have to win not just on cost and on tracking, but also have to match the openness </li></ul><ul><ul><li>Make collateral rules easier to find </li></ul></ul><ul><ul><li>Disclose collateral portfolios as well as index portfolios </li></ul></ul><ul><ul><li>This information is already available to institutional investors </li></ul></ul>
    24. 24. Expansion of the Retail Market: Cross-Border Transactions <ul><li>Liquidity makes ETFs a winner-takes-all competition </li></ul><ul><ul><li>Institutions will trade across borders for the best execution </li></ul></ul><ul><ul><li>Retail investors need to be able to do the same </li></ul></ul><ul><ul><li>This trend is already coming to fruition, as several retail brokerages offer fairly inexpensive trading throughout the EU </li></ul></ul>
    25. 25. Consolidation in the European ETF Marketplace <ul><li>This winner-takes-all competition for liquidity will drive consolidation in the ETF marketplace </li></ul><ul><ul><li>One or two “winners” will take the vast bulk of assets and trading volume for any given index to track </li></ul></ul><ul><ul><li>Despite having lower assets and not much growth, many smaller funds will remain alive on assets from in-house customers </li></ul></ul><ul><li>Off-exchange distribution channels can not drive this consolidation </li></ul><ul><ul><li>Liquidity and low trading costs are the draw of the top funds, and they do not carry over to off-exchange distribution </li></ul></ul>
    26. 26. Product Innovation Will Continue <ul><li>New entrants in a more mature market can only compete on low costs or product innovation </li></ul><ul><li>Plenty of new areas ripe for expansion </li></ul><ul><ul><li>Fundamentally-weighted indices </li></ul></ul><ul><ul><li>Screened indices </li></ul></ul><ul><ul><li>Active ETFs </li></ul></ul><ul><ul><li>Funds of hedge funds </li></ul></ul><ul><ul><li>“ Alternative beta” </li></ul></ul>