Friday, June 03, 2011 12:48 (CET)
Posted By Paul Amery
The comparison of exchange-traded funds (ETFs) with collateralised debt obligations (CDOs), made by Terry Smith a couple of days ago, is nothing new. London-based hedge fund and gold investor Hinde Capital made a similar argument last summer, saying that gold exchange-traded funds like State Street’s GLD are full of embedded structural risks, resemble CDOs and should be avoided.
In both cases—Smith’s and Hinde’s—one has to bear in mind that the arguments come from observers with an axe to grind. Smith has his own actively managed fund to sell, which comes with a total expense ratio of 1.25 percent a year, while Hinde offers you the opportunity to buy a fund that invests largely in allocated physical gold, but charges 1.5 percent flat a year, plus 20 percent of any gains, and with only monthly liquidity, to do so. That’s turned out to be much more expensive than the 30-40 basis point annual cost to own the average gold ETF or ETC.
But do these ETF critics have a point? And what should the average investor make of the comparisons between a fund type (ETF) that’s been collecting assets fast and a type of bond (CDO) that nearly brought down the whole financial system?
That there’s financial engineering in many ETFs is undoubtedly true, while ETF issuers haven’t exactly gone out of their way to highlight this. By some accounts, the issuers of physically backed ETFs are making as much in revenue from the lending out of the securities in their funds as they are from the fund fees, or possibly even more, while there are economic incentives for issuers of swap-backed ETFs—well described in the FSB and BIS papers released in April—to use the funds as a cheap financing vehicle for the parent bank, as well as possibilities for regulatory arbitrage.
Does this resemble what went on in the average CDO? In my opinion, ETF risk is not on the same scale.
CDOs had a fundamentally flawed structure, using bad maths to model possible risks, and this was made much worse by the misuse of credit ratings. If the ETF market had an “independent” ratings service rubber-stamping funds as offering effectively risk-free extra return, as was the case with CDOs, I’d be much more concerned.
CDOs based on mortgage-backed securities also had illiquid, poorly understood collateral, which relied on a fundamental assumption that the housing market would always rise. ETF collateral policies are not based on any such assumption. Nor do ETFs contain the difficult-to-model correlation risks between tranches that CDOs incurred as a matter of course.
It’s fair to say that synthetic ETF structures haven’t yet experienced the failure of a bank counterparty, and that therefore we can’t be sure what tail risks might occur. The scenario analysis I’m aware of suggests that the worst that could happen for investors in a counterparty failure is (a) that there could be a delay in accessing the collateral, and (b) that there is some risk that the collateral’s value may fall short of the amount investors are owed; but not that the collateral might not be there at all. A delay in getting their money back wouldn’t be pleasant, by any means, but is there a likelihood that an ETF’s collateral could turn out to be worth only 10 percent of its face value, as was the case with some “AAA”-rated CDOs?
I’ve heard stories in the past of certain synthetic ETF issuers holding a structured note issued by the parent bank as part of the collateral basket, potentially increasing counterparty risk from the 10 percent maximum allowed under UCITS rules to 20 percent. Having said that, the trend towards more widespread, daily disclosure of synthetic ETF collateral by many issuers, plus the maintenance of higher overall collateral levels, has been improving practices in this area.
Are collateral and counterparty risks difficult for the average investor to understand? Yes. Are ETF collateral risks on the same scale as those incurred in CDOs during the last decade? Not that I can see.
Regulators have been more circumspect than to make a direct ETF-CDO comparison, though Mario Draghi, FSB chairman and future president of Europe’s central bank, did say a couple of months ago that “ETFs are reminiscent of what happened in the securitisation market before the crisis”. In its ETF paper, the FSB spoke specifically of the heightened risks of potentially dangerous financial innovations during periods of low interest rates.
Ironically, the near-zero interest rate policies that are creating skewed economic incentives across the board come from the same central bankers that populate the boards of the multinational regulators.
That aside, the debate over the structural risks in ETFs that the regulators have provoked has undoubtedly been a healthy one. I’ve lost count of the people from within the exchange-traded fund industry who’ve told me (off the record) that they felt the IMF, FSB and BIS raised several valid points of concern.
But are ETFs as risky as CDOs? I don’t think so.
The Costs Of Switching Bonds
As Tracy Alloway explained in a feature article earlier this week, covered bonds are attracting investor interest for two reasons: regulators are encouraging banks to issue them by giving covered bonds lower capital charges than unsecured debt under the new Basel III rules; and investors are attracted by the fact that they are collateralised and are (so far) considered as unlikely to share in possible future bank “bail-ins” (loss-sharing).
Not all investors are crazy about covered debt, though. You have to give up some yield to switch from holding unsecured debt to owning debt that’s further up the capital structure of the issuing bank—85 basis points a year in the case of a recent seven year covered bond issue from the UK’s Coventry Building Society, according to a recent news story from Institutional Investor.
Other sceptics point to the fact that the “cover” in the covered bonds may not be as watertight as it sounds. Spanish banks, for example, have been issuing record amounts of covered debt but reveal relatively little about the performance of the mortgages backing the bonds, said one concerned investor.
Also, rules on the extent to which covered bonds push other bank creditors (depositors and holders of senior/subordinate unsecured debt) down the repayment pecking order may vary from one European country to another, Tracy reminds us in her IndexUniverse.eu feature.
Nevertheless, ETF holdings show that an increasing number of investors are making the switch from unsecured to secured debt.
iShares’ Markit iBoxx Euro Corporate Bond fund (LSE: IBCX), for example, Europe’s largest corporate bond ETF, has seen around 20 percent of its assets leave since last September. It tracks an index that has half of its assets in the unsecured debt of European financial companies, so this perhaps reflects increasing concerns that senior bank debt might indeed face future losses.
Meanwhile, iShares’ Markit iBoxx Euro Covered Bond ETF (LSE: ICOV) has seen its assets more than double in the last six months, with inflows accelerating of late.
And you actually get a yield pick-up trading out of IBCX into ICOV, from a redemption yield of 3.25 percent to 3.88 percent, according to the iShares website. If that appears to contradict what I said earlier about covered debt paying lower interest rates than senior unsecured bonds, in this case it’s explained by the index composition. IBCX has around half its assets in non-financial bonds, which currently pay less interest than financial debt, on average, while ICOV has a heavy (28 percent) weighting in covered banks issued by Spanish banks, which are perceived by the market as riskier and have been paying higher rates as a result.
There’s also a significant difference in the ETFs’ trading costs, according to issuer iShares.
For the first four months of 2011, the average time-weighted bid-offer spread on the London Stock Exchange was 12 basis points for IBCX but over double that, 29 basis points, for ICOV.
Remember, also, that recent months have witnessed relatively benign market conditions. In more volatile times, these dealing spreads may well rise. You don’t have to go as far as the alarmism of Dan Fuss, bond fund manager at Boston-based Loomis Sayles, who warned earlier this week in FTFM that ETF investors could face “haircuts” of up to 10 percent in corporate bond funds if they all tried to sell at once, to realise that we’re dealing with a sector of the market more suited for buy-and-hold investing than for trading.
Comparing Like With Like
Terry Smith’s broadside against ETFs from earlier this week, echoed today by Jonathan Guthrie, City editor at The Financial Times, has now been met by a counterattack. Alan Miller, former equity fund manager and now owner of SCM private, a wealth management firm, challenges Smith head-on in an opinion piece in The Daily Telegraph.
Smith highlights counterparty and collateral risks in ETFs as a major concern, then goes on to claim that the combination of short selling and exchange-traded funds may be creating little-understood structural risks, which could in turn lead to a repeat of last year’s flash crash.
Not so, argues Miller. By comparison with the disclosure levels offered by the average active manager, says Miller, ETFs are a paragon of openness. “Fundsmith (Smith’s active fund vehicle) shows the list of its top 10 holdings by name (but without percentage held) on a monthly basis,” says Miller. “According to the Fundsmith website, it holds 23 stocks within the fund, of which it reveals just 10. [By contrast] most ETFs show every single holding in full, and with percentages, daily.”
And when it comes to the risks incurred by high levels of short selling via ETFs, continues Miller, these pale into insignificance when compared with the sometimes highly illiquid stocks held by active funds.
“Most large ETFs follow large liquid indices, such as the FTSE 100 or S&P 500,” says Miller, “so there are no liquidity issues with these funds being very large indeed. In fact, the action of the market makers and hedge funds using ETFs as an efficient, liquid hedge against their exposures increases the trading volume of ETFs, thereby reducing their spread and therefore cost to investors.”
“In fact the danger is much greater in several of the largest popular UK mutual funds, Miller goes on. “One £1 billion-plus UK fund, for example, has holdings in several small-/mid-size UK companies where, together with other internal funds, they hold nearly 30 percent of the equity. What would happen if this high profile manager were to be run over by the proverbial Clapham omnibus and investors all decided to sell?”
So who’s right—Smith or Miller?
Let’s start with counterparty and collateral risks. These undoubtedly exist in ETFs—whether swap-based or physically backed. But the same risks are present in many actively managed funds too, and usually with levels of disclosure that are far lower than those offered by ETF providers.
In Fidelity’s investment funds simplified prospectus (taking one of the largest mutual fund operators in the UK as an example) it’s clearly stated that “for funds that use derivative transactions, there is a risk that the counterparty to the transaction will wholly or partially fail to honour its contractual obligations. This may result in financial loss to the fund”. Fidelity’s website doesn’t disclose to whom derivative exposures are incurred on behalf of fundholders, how counterparty risk exposures are managed and what collateral is provided to back derivative contracts used by the manager’s funds. The average ETF issuer discloses all these things (although some are more open than others when it comes to the frequency and quality of collateral disclosure).
And active fund managers lend out securities just as ETFs do. ETFs and index funds lend out more stock, on average, than actively managed funds (since their holdings are more stable over time, making them a more reliable source of stock for the borrower), but the same questions of collateral management and counterparty risks apply in active funds as they do in their passive cousins. Whose disclosure is better? Again, almost certainly ETFs’, though it’s not great for either type of fund when securities lending is involved.
What about the potential for trading problems in ETFs? Miller points out that many ETFs track highly liquid indices, though Smith posed a slightly different question, focusing on the potential problems that could arise if those heavily short on an ETF tracking less liquid small-cap stocks (for example) all needed to cover their short positions at once.
To me, both men have a point here. Miller argues that ETFs have generally tracked well, in silver, for example, throughout the recent, highly volatile period. But Smith is worried about ETFs’ promise of real-time liquidity, something that may be difficult to achieve in practice when less liquid underlying areas of the market are a fund’s focus. Here, Smith is restating the concerns voiced by regulators a few weeks ago. And, as we wrote in March, even in major equity markets ETFs may not guarantee the continuous trading they promise. Are these funds misrepresenting the real liquidity they can offer investors?
This is a fiendishly difficult question to answer. Sudden investor withdrawals could pose a problem, as Miller argues, in actively managed funds investing in smaller stocks, even if redemptions can only take place daily. In 2008 we saw that even the monthly “gating” mechanism of hedge funds was insufficient to quell panic. Meanwhile, in last year’s flash crash, some ETFs went from trading with tiny spreads and apparently healthy volumes to drying up completely in a millisecond.
Weighing all this up, and if we can try to divorce the question of fundamental liquidity from questions of market structure (which, I believe, caused the flash crash), all we can really say is that an ETF can’t make the underlying asset more liquid than it is by nature. And with ETFs moving into areas of the market that are less liquid and more difficult to track, this is potentially a much bigger concern than it was when such funds were based only on the S&P 500 and the Nasdaq 100.
Finally, who’s right on the risks of ETFs operating with high levels of short interest? Given the open-ended nature of the exchange-traded fund structure there shouldn’t be a problem in high short interest levels per se, though it’s clear that operational risks (the risk of a chain of settlement failures, for example) go up when more shorting is based on a single ETF issue, given the multiple layers of ownership involving all the shorts and the longs.
But when Smith argues that “you may have thought you bought an ETF but what you think you own may actually have been lent to hedge funds” (or words to that effect) he’s surely being disingenuous. After all, this is just what may be happening when you buy an actively managed mutual fund. That fund’s shares may have gone on loan to a short seller too, being replaced (temporarily) by some form of collateral. Come to think of it, that £100 you put in the bank last year may have been lent out by the bank 50 times over as well.
Returning to the question of an ETF with a high short interest, if this led to a price squeeze in the stocks the ETF is tracking (this risk, which Smith points out, is undoubtedly a real one), this would actually benefit owners of the fund (though it would cause losses for those short on the ETF).
Some people may be uncomfortable with short selling as a concept, or with the idea that a single fund or security can be lent out many times over. But these concerns should be addressed within debates over short selling and securities finance (or financial system leverage in general); ETFs are merely offering one illustration of the fact that such practices exist.
There was an excellent discussion last year of the whole topic of ETF short interest, creation and redemption on the FT Alphaville and Kid Dynamite blog sites. Some of the well-reasoned comments on those blogs ultimately convinced me that the scare stories on this particular issue are overblown.
But the current, furious debate over ETF risks must surely be seen in the context of a much broader discussion. And that’s about the future of the fund management business. How are costs to be measured and what underlying risks are being incurred to earn a fund’s returns? What about the asymmetric risk/return profile of the performance fees that many active managers charge? How do regulated funds compare with the myriad other ways that people can access markets—structured products and spread betting, for example? All these are ways of constructing what are, ultimately, vehicles for people’s hard-earned savings. Making a like-for-like comparison between them is a very challenging task. It’s also an ever more urgent one.
Contagion Spreads Beyond Greece
Two charts put out yesterday by Markit’s credit analyst Lisa Pollack suggest that contagion risk may be moving to European countries previously considered safe.
The first chart shows the net notional exposure to credit default swaps (CDS), referencing the three countries currently priced by the CDS market as most likely to default (Greece, Ireland, Portugal, in that order). The net notional value of CDS represents the sum of default protection purchased by buyers in the market, and is therefore a gauge of the level of investors’ interest in insuring against the risk of the relevant country defaulting on its debts.
The second chart measures net notional CDS volumes for the five largest European economies: Germany, France, the UK, Italy and Spain, over the same period.
Demand for credit protection against Greek default has actually fallen by over a third during the last year, points out Pollack, while for Portugal and Ireland the volume of insurance written via CDS has also fallen substantially.
The first chart is prima facie evidence that Greece’s slow drift towards default is not being provoked, as some European politicians have suggested, by speculators buying huge volumes of CDS to push credit spreads wider. The absolute level of CDS protection purchased on Greece—around US$5.5 billion—is also small when compared with the country’s total debt (€310 billion, according to the BIS).
There are also some technical factors behind the fall in demand for CDS on Europe’s riskier countries. For example, Portugal took the lead last summer in agreeing to post collateral with its market counterparties (historical market practice has been for postings of the collateral underlying derivatives contracts between banks and sovereigns to be one-way only, meaning that governments have historically insisted on some form of security from bank counterparties to back the latters’ promises, but have typically not felt obliged to offer the same surety in return). With this particular government now offering collateral to dealers, says Pollack, demand from the market to buy default protection has fallen.
However, there’s been a sharp rise in net notional CDS outstanding on the supposedly safer sovereign credits in Europe, as the second chart shows. Demand for protection against a French default has doubled in a year, for example, while for the supposedly default risk-free UK (given the country’s control of a currency that it can, in theory, devalue at will) there’s been a six-fold rise since 2008 in the volumes of CDS held.
Part of the rise in demand for sovereign credit risk insurance over the last few years has come from banks’ internal credit departments, which have undergone a complete reassessment of the way they monitor and hedge counterparty exposures since the financial crisis, says Michael Hampden-Turner, credit strategist at Citi. Whereas previously most sovereign bonds and exposures to governments via derivatives contracts were considered risk-free by dealers, since 2008 these have all been hedged as a matter of course, he explains, and banks have dedicated counterparty valuation adjustment (CVA) desks to fulfil this role. A decent part of the increased demand for sovereign CDS is coming from such sources, says Hampden-Turner.
However, with the rise in demand for CDS protection on Europe’s largest countries, it’s also easy to see that investors are hedging against the risk of contagion from the weaker periphery. This is particularly the case since Europe’s blind insistence on a “no default at any cost” policy has had the effect of tying the stronger EU member states to the riskier ones, via such bailout programmes as the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).
Although we’ve ignored the price of insurance—the cost of default protection for Germany (45bp), France (79bp) or the UK (58bp) is still ten or 20 times lower than for the most stressed Eurozone states—the steady increase in interest in hedging against the default risk of governments previously considered rock-solid is a trend worth following closely.
Forget Greece, where default is surely a done deal and it’s only a question of when and whether it’s a single or two-step write-down of debts. It’s French, German and UK CDS contracts you need to watch if you want to gauge the real risks to the financial system.
Iceland’s Index Lessons
According to the IMF, Iceland’s 2008 banking collapse made it into the history books as the largest finance-driven GDP decline ever, as our guest blogger Tyler Mordy pointed out earlier this week.
By refusing to engage in a futile attempt to prop up insolvent banks, the country has also shown the rest of Europe a way forward when it comes to dealing with the aftermath of a credit bubble. While the rest of Europe carries on turning private bank debts into sovereign obligations with limited or no public debate, Iceland’s voters have twice been offered the chance, via referenda, to use taxpayers’ money to refund foreign depositors in now defunct Icelandic savings institutions. They have voted no on both occasions.
Iceland’s boom and bust is shown graphically by the history of the OMXI15 index, which rose nearly six-fold during the noughties, reaching a peak of over 9,000 points in July 2007. From that high point it lost nearly all of its value, falling by 97 percent over the next year and a half.
By late 2008, the index’s three leading constituents from earlier that year, all banks—Kaupthing, Glitnir and Landsbanki—had disappeared completely. In fact nine of the 15 stocks used to make up the equity benchmark in early 2008 were gone from the index a year later.
When Nasdaq OMX, owner of the Reykjavik stock exchange, tried to put together a constituent list for the OMXI15 for the first half of 2009, it couldn’t even find 15 suitable local stocks to include, and had to settle on 12.
Given the index’s traumatic history, it’s no surprise that the exchange gave up on the OMXI15 completely in 2009 and replaced it with a smaller, six-stock benchmark, the OMXI6, which currently includes two airlines, an oil company, a food processor, a manufacturer of orthopaedics and only one bank. With Nasdaq OMX planning its first Reykjavik listing in three years this summer, there may soon be a larger list of constituents for the index compilers to choose from.
But are there any broader lessons for index investors from Iceland’s financial collapse?
First, as many have pointed out, capitalisation-weighting during market bubbles lands you with exposure to the sector that is most prone to a bust. Although Iceland was an extreme example, 89 percent of the main stock market index was in financial stocks in early 2008.
Second, liquidity screening and free float adjustments don’t provide much protection. Screening stocks for liquidity prior to ranking them by market capitalisation is a commonly used way of constructing indices for investment purposes, but in Iceland’s case the most traded stocks were also the most bubbled-up prior to the collapse. Large (50 percent-plus) free float adjustments to the top four stocks in the index in early 2008 (a result of Iceland’s complex web of company cross-holdings) still left you with a cumulative 75 percent exposure to those names.
Third, approaching investing via country indices is simply a bad idea. If you thought a couple of years ago that by using Iceland’s main stock market benchmark you’d be accessing the country’s primary economic sectors of fishing, geothermal energy and mining, you’d have been completely wrong.
We’ve written before about how national benchmarks may be far from representing domestic industries, with the FTSE 100 a good example. The compilers aren’t going to stop promoting such brand name country indices. It’s puzzling, though, that so much money in the European ETF market is still invested in funds tracking them.
The views expressed by those blogging are for informational purposes only and should not be construed as a recommendation for any security.