“The only thing worse than being talked about is not being talked about,” said Oscar Wilde in The Picture of Dorian Gray. This should console those in the ETF industry, licking their wounds after last week’s three-pronged attack from no less than the G20’s Financial Stability Board (FSB), the International Monetary Fund (IMF) and the Bank for International Settlements (BIS). ETFs’ importance to securities financing is growing all the time, so it makes sense to review these reports since securities lending is included in the list of issues cited by the FSB. It makes sense to begin by reviewing which ETFs are seeing most flow from those investors oblivious to the industry politics.
The ETFs—SPDR S&P500 (NYSE:SPY), Powershares QQQ (NADSAQ:QQQQ) and iShares Russell 2000 (NYSE:IWM)—that physically track the world’s largest equity indices typically top the table of those seeing the most securities lending. Plus, the trend to invest in both gold and emerging markets makes ETF-related instruments popular for hedging, such that the SPDR Gold Shares (NYSE Arca:GLD) and iShares MSCI Emerging Markets (NYSE:EEM) are perennial favourites to borrow these days.
More recently popular to borrow is (Bank of America) Merrill Lynch’s Semiconductor ETF (NYSE:SMH). There is also recent momentum in demand to borrow natural gas themed ETFs, particularly ETFS Lev Nat Gas (BIT:LNGA), ETFS Natural Gas (BIT:NGAS) and United States Natural Gas Fund (NYSE:UNG). This could be to hedge long positions, given the focus on this form of energy as oil and nuclear suffer. As with all ETF borrowing there are typically two motivations: to hedge a long position in the sector through holding one or many single stocks, or to take a directional view to profit from falling prices in the sector, without long exposure.
Short Interest In UNG
The Financial Times presented the arguments that ETFs make shorting too “easy” and thereby encourage it where it wouldn’t normally occur. However, those advocates should be mindful of an equally easy counter-argument. We know from contact with the hedge fund community (especially in the US) that ETFs are mainly used to hedge their ownership of shares in case their bullish view is wrong. Given that hedge funds are paid to perform in all market conditions, it could be said that the existence of a liquid hedging tool such as an ETF is a pre-requisite to making an investment in the first place.
Much of the criticism contained in the reports was focused on synthetically-backed ETFs, nicely summarised by Paul Amery, who explains the difference between funded and unfunded swap structures and the implications for collateral and risk-weighted capital charges. However, physically backed ETFs (i.e., those that actually own the underlying shares in the sector/index they represent) did not escape unscathed.
The fact that securities lending income is now recognised as the way in which ETFs can offer such low fund charges makes the report’s authors suspicious. If the more you lend, the more you earn, it follows that the boards presume that the issuers must be aggressively pushing their stock out the door. The authors are concerned that this makes short squeezes and price volatility more likely and creates unnecessary counterpart exposure. However, they fail to realise that you can only lend what someone else wants to borrow. Income from lending equities is well known to have fallen at least 40 percent since the financial crisis due to vastly suppressed demand to borrow, yet this has not led to a rise in ETF fund changes. Therefore, securities lending income is clearly not the sole reason why charges are so low.
It is also worth pointing out what actually happened when the last counterpart defaulted, which was Lehman in 2008. Very little money was lost from those who had lent securities to Lehman. In fact, the rebound in the equity markets meant that many made money in the process of selling their collateral to buy back what was on loan to the defaulted counterpart.
Despite physical and synthetic ETF providers publishing more and more information about their business, (the ETF lending revenue split between the investor/fund manager, the SL revenue and the daily collateral schedule) people will always want more. There is currently a battle between the two types of ETF creators as to which can be the most transparent, meaning they are generally willing providers of information. This is exactly the situation the regulators want and is good for investors.
Having missed the dangerous implications of securitisation, committees of wise men are queuing up to pin every last sin upon an ETF. If you believe everything you read the world will end and ETFs will be to blame. Some of the more whacky accusations include fostering insider trading and discouraging companies from listing.
At this stage, it is hard to remember that ETFs actually offer a cheap, liquid and less risky way to invest. If financial “artistry” and innovation is to survive, one would do well to take another piece of advice from Mr. Wilde: “The critic has to educate the public; the artist has to educate the critic.”
Will Duff Gordon is director of research at Data Explorers. To hear more on this subject listen to the firm’s presentation at Index Universe’s ETF conference in Amsterdam on the 5-6th May, or attend Data Explorers’ NY Forum on 26 May.