Since the start of the credit crisis I’ve frequently heard the comment from investors that they prefer to avoid counterparty risk when investing in ETFs (and tracker products in general). But are they really prepared to pay to obtain this, or is it more a question of “make me chaste, but not yet”, as Saint Augustine once famously declared?
At Terrapinn’s conference in London on Monday there was a revealing moment when one investor said that he preferred ETFs that use direct (physical) replication as their tracking technique, since he could then go to his clients and explain that they own a fund which consists of the underlying shares in the proportions given by the index, rather than a portfolio containing a basket of possibly unrelated securities, plus some financial derivatives (in other words, a typical swap-based ETF).
“What about when the index securities are lent out?” asked MJ Lytle, head of marketing at Source, an ETF provider that uses swap-based replication for its funds. Lytle pointed out that when a fund lends its securities it is entering into another kind of derivative transaction – a physically settled forward contract. Since most ETF providers that use the physical replication technique do lend the index securities from within their funds, he said, counterparty risk exists in both types of ETF structure commonly used in Europe.
If you accept this argument, and I think Lytle's point is undeniable, the waters get a lot muddier for investors. Unfortunately, it cannot be a question of physically replicated equals good, swap-based equals bad from the point of view of counterparty exposure, as some have naively suggested.
So, when assessing the relative merits of each type of ETF structure, investors must take into account quite complex considerations such as the level of collateralisation provided, the nature of the collateral and the degree to which its performance is correlated with that of the index, the frequency and robustness of procedures ensuring collateral resets, and the degree of transparency over precisely to whom counterparty exposures are incurred.
At this point a number of institutional investors will undoubtedly shrug their shoulders and – perhaps – buy ETFs on the same index from a number of different providers to ensure diversification of a different kind. If you’re smaller fry then you’ll probably go for an ETF provided by a bank you prefer or whose name you recognise – if you even have a choice of provider on your domestic stock exchange, that is, for the index you want to track.
And, after all, since almost all European ETFs fall within the UCITS regulatory framework, which ensures that certain minimum standards are being adhered to and which limits the absolute level of counterparty risk in ETFs, even in the case of a default you should get most of your money back. So perhaps it’s important not to overdramatise the risks here, or at least to put them into some kind of perspective.
If investors really want a “no counterparty risk” ETF – one that owns only the index securities with no lending – they could surely get it. The total expense ratio for such a fund might be nearer to a percent per annum than the 30-35 basis point average fee currently charged by European ETFs, one provider told me this week. Perhaps an ETF issuer should take up the challenge?