iShares has increased its stranglehold on the European ETF market over the last two years. But could things be about to change?
BlackRock’s ETF platform secured 70% of all net new cash flows to Europe’s exchange-traded fund market in 2011 and is well ahead of the competition so far this year. Meanwhile db x-trackers and Lyxor, Europe’s largest issuers of synthetic (swap-based) tracker funds, have seen their businesses shrink over the same period, in Lyxor’s case significantly.
But BlackRock’s 2011 call for the European ETF market to be reclassified formally into two fund categories, physically replicating and derivatives-replicating, has so far fallen on deaf ears.
It’s clear that Europe’s securities market regulator, ESMA, has no appetite to revisit the rules for retail funds’ use of derivatives and to split the UCITS market in two, a move that BlackRock’s suggestion would effectively entail.
Meanwhile, it seems to me that two of ESMA’s new ETF guidelines could even have the effect of transforming the competitive landscape to favour bank-owned, derivatives-based replicators.
First, there’s ESMA’s requirement that the revenues from securities lending operations should be returned to fund investors, net of the costs involved when operating such lending programmes. This will dent the profitability of the issuers of physically backed ETFs. Currently, BlackRock keeps 40% of the net revenues it generates from lending out the holdings of European ETFs, State Street 50%, for example.
Meanwhile, for synthetic issuers there’s no equivalent requirement to pass on in full to investors the earnings from the financial engineering that’s inherent to swap-based funds. To recap (and this is something we covered in detail in our March webinar, “Uncovering the True Costs of ETFs”), any difference in quality (measured as an implied “repo rate”) between the basket of stocks constituting the index and the basket of stocks being held as collateral can generate a real economic benefit for the swap counterparty. If that swap counterparty is part of the same banking group as the ETF issuer, those extra earnings can be pocketed.
Second, ESMA has recommended that ETFs should in future publicise their anticipated level of tracking error. This move, at first glance, clearly benefits synthetic funds, since they tend to produce a smoother return by design.
This, in turn, is because in a synthetic structure the risks of tracking the index are fully outsourced to the derivatives counterparty, while in a physical ETF any difficulties involved in holding the full index basket and the resulting performance differentials are reflected directly in the fund’s return. Incidentally, this is likely to be one of the reasons why physical ETF issuers don’t give up on securities lending completely under ESMA’s new rules: lending revenues can help smooth fund tracking.
But the risks to physical ETFs from this new guideline are real. Remember the US-listed iShares emerging market equity ETF that underperformed its benchmark by more than 6% in 2009? Describing your fund’s likely tracking error and then missing the target will be a potential minefield for the firms involved. These tracking risks are arguably getting larger as ETFs move increasingly into less liquid areas of the asset market. High-yield corporate bond ETF tracking error, anyone?
So, after a bruising couple of years, that’s two reasons why synthetic ETF issuers must be feeling a little better after the release of ESMA’s new guidelines. For Europe’s bank-owned fund managers to breathe a full sigh of relief, though, will require the eurozone debt crisis to pass its peak—and that’s another matter.