Monday, May 16, 2011 15:33 (CET)
Posted By Tyler Mordy
Lessons From Reykjavik
Looking out over Reykjavik’s old harbour recently, I wondered if global investors could learn anything from Iceland’s recent banking crisis. After all, the country is small fry on the world scale, with a population barely reaching 300,000 and an economy of just US$ 12.7 billion.
Yet, in less than a decade, Iceland morphed into a financial goliath, swapping much of its fisheries-based economy for activities in high finance. No surprise then, that according to the IMF, Iceland’s banking collapse relative to GDP is the largest suffered by any country in financial history.
Nothing enlarges the financial share of national income like booming lending conditions. By 2007, the three main banks — Kaupthing, Glitnir and Landsbanki Island — comprised 77 percent of Iceland’s stock market capitalisation and had loan assets equivalent to more than nine times the country’s GDP.
Shockingly, four-fifths of these loans were denominated in overseas currencies. So-called “Viking capitalism” (or útrásarvíkingur) transformed the country.
That era is now confined to the history books and Iceland’s banks have been nationalised. The local stock market is down more than 92 percent from its 2007 peak. The krona has lost almost 60 percent in value relative to the euro. And, the ubiquitous Range Rovers of yesteryear are conspicuous in their absence (now called “Game Overs”, according to one local).
Indeed, high finance has been brought low.
Where to next? Much comparison has been made with Ireland’s situation. Both economies had horrifically overleveraged banking systems and soaring private sector debt.
The key difference, however, lies in their adjustment paths. Ireland, constrained by the dual shackles of a common currency and forced fiscal austerity, has not been able to resort to currency devaluation to stimulate nominal growth in GDP. That has led to wide divergences in the respective recovery profiles between the two countries. Most evidently, as a result of its currency devaluation, Iceland has been able to maintain growth in nominal GDP. Ireland has not. That means Ireland has opted for a likely period of Japanese-style protracted economic stagnation, while Iceland’s recovery will be more robust.
Another difference is Iceland’s refusal to turn private bank debts into sovereign obligations (even with pressure from Britain and the Netherlands to repay funds lost in the now-infamous Icesave banking failure). Not surprisingly, this is a political hot potato with extreme implications for other jurisdictions.
But taxpayers’ refusal to underwrite their country’s bank debts is gaining ground. Last month, a second referendum was held to decide if the government should make foreign depositors whole. Nearly 60 per cent of Icelandic voters rejected the proposal.
There are many unanswered questions that lie ahead for Iceland and the global economy at large. Some are expecting a return to the same credit-driven growth of recent years. The recent counter-trend rally since March 2009 has certainly encouraged those hopes.
But post credit-crisis environments are clearly different beasts. Historically, the aftermaths of severe financial crises—regardless of their adjustment paths—tend to share a number of characteristics. Most importantly, they are always protracted affairs, involving a long corrective period where economies become accustomed to lower aggregate demand. New industries spring up and old ones die. This takes time.
The state of affairs we’ve just described is clearly not an issue for Iceland alone. Many advanced nations are also facing headwinds in a post-financial crisis environment. Employment, income growth and private credit formation are all not rebounding fast enough to produce robust top-line GDP growth.
That doesn’t mean that intermittent growth spurts will not surface (such as is the case now). But the secular trend is for slower growth. Indeed, Viking capitalists are likely to be in retreat for some time. That will require tweaking in global approaches to investing. What’s right in one regime may be wrong in the next.
Tyler Mordy is a portfolio manager and director of esearch at Hahn Investment. He stopped off in Iceland on his way home from the recent Inside ETFs Europe conference.
Active ETF Or Active Strategy?
For me, some of the most interesting debates at the Inside ETFs Europe conference last week were those on indexing and how the benchmarks used by exchange-traded and index funds should be constructed.
In “The Future Of Indexing In Europe”, there was a lively discussion between Paul Kaplan of Morningstar, in one corner, and Denis Panel of BNP Paribas Asset Management, promoter of the EasyETF range, in the other.
In France, said Panel, there’s a real demand for more efficient indices than the traditional capitalisation-weighted versions. Cap-weighted indexing is only efficient if you accept the framework of the Capital Asset Pricing Model of classical portfolio theory (where a cap-weighted portfolio represents the optimum weighting scheme from a risk/return perspective), argued Panel, but if you don’t (and there is plenty of empirical evidence to suggest CAPM is flawed), then you should look beyond this means of indexing. “Risk-based indexation is the future,” Panel concluded.
Not so, said Kaplan. Non-cap-weighted approaches, such as Research Affiliates’ fundamental indexation, are interesting, but they represent a value tilt and thereby a bet against the market, and should be recognised as such, he argued. Furthermore, continued Kaplan, there hasn’t always been “truth in advertising” by the promoters of non-standard index variants.
There’s no value bias in fundamental indexation, added a third voice, from a member of the audience. Fundamental indexing is indifferent to value—it’s cap-weighting that lands you with an inherent bias to growth stocks (and to overexposure to market bubbles).
In another index-focused session, Hartmut Graf, chief executive of index provider Stoxx, commented on the growing tension between index coverage and tradeability that is resulting from the increasingly widespread use of cap-weighting, while Isabelle Bourcier of Ossiam said that strategy, as opposed to cap-weighted indices, allows investors to manage risk more intelligently and efficiently.
Add in the debates from the second day of the conference over the most appropriate way to index equities, fixed income and commodities, and a substantial proportion of the event was devoted to sometimes abstract, but always interesting, theoretical questions of benchmark construction.
But there’s an increasing trend in Europe, it appears, towards the embedding of a wide variety of investment strategies within the indices that ETFs follow. These “strategy” ETFs usually come at a price premium to more traditional cap-weighted funds, and it’s worth remembering panelist Lars Kroijer’s comment that, if you apply the extra fees charged by strategy ETFs only to the portion of the portfolio where index weights differ from those used in traditional index trackers, then you end up with a management charge akin to a hedge fund fee (albeit without the performance kicker). On the other hand, it’s also fair to point out that a few years ago most systematic, rules-based equity selection strategies offered by fund managers tended to be offered only in hedge fund structures, with the equivalent (high) fees. Having such strategies available in ETF format, and at a lower, flat rate charge, is therefore a step forward for investors.
While the question of an ETF’s underlying investment strategy was the subject of broad debate at last week’s conference, there was almost no discussion of one of the hotter topics in the US ETF market, that of active ETFs.
As my colleagues in the US have reported, there’s been a flurry of applications in recent months to the Securities and Exchange Commission for the launch of active ETFs, many of them from fund managers who had previously been absent from the ETF market.
Although the SEC has so far only approved applications for “transparent” active ETFs—those that publish their portfolio holdings daily—it’s also sitting on a number of requests for non-transparent active ETF structures, which would publish their holdings less frequently.
As always, the more you move away from full transparency of the underlying fund holdings, the more difficult it is for market makers to price ETFs for intraday trading. The less transparency there is, the more we’ll charge in terms of bid-offer spread, one trader reminded a gathering of ETF specialists last week.
There have been some active ETF launches in Europe—Pimco Source’s recently listed Euro Enhanced Short Maturity ETF comes to mind, while last year’s MW Tops Global Alpha ETF is another variant, albeit of a very different investment profile.
However, despite the noise being made in the US market about such funds, there appears to be limited demand for them in Europe, a conclusion that was drawn in Edhec’s 2010 ETF survey, released late last year.
European ETF investors appear to be more interested in embedding active management strategies (or strategy tilts) within an index for tracking by an exchange-traded fund, rather than attempting to make the fund itself actively managed.
A Lode Of Silver ETP Choices
The Easter roller coaster in silver helps remind everyone of the massive volatility difference between equity-backed funds and commodity ones. In truth, silver ETFs are actually exchange- traded commodity products (ETCs), which is a key difference.
But for investors with their eyes open, the variety of investment vehicles presents a rich vein of choices during this stomach-churning ride. This is key, as greater choice offers improved liquidity, something those behind the FSB/IMF/BIS reports should bear in mind along with the fact that exchange-traded instruments simply track an index (more on that later).
Until these various products were available, plain silver mining companies like Fresnillo (LSE: FRES) were the only available option. On April 28, the main silver fund, the iShares Silver Trust (NYSEArca: SLV), was up 30 percent in the month, compared with a 10 percent rise in the price of Fresnillo. So far, so good for those ETF traders—no individual company risk and a return that was three times higher.
Those that felt this difference in price was evidence of retail speculation could simply sell their holdings and walk away. As an alternative, they could have shorted the iShares Silver Trust or taken out protection in the options market. According to Data Explorers, there were 12 million shares short for SLV, or 3.5 percent of the market cap last week. Amazingly, so much insurance was being bought in the options market on April 27 that there were more silver-related contracts being struck than those based on the movement of the overall S&P 500!
On the above evidence, if you smelled a bursting bubble at this point and felt brave, you would have bought the ETF that went up when the price of silver went down. The ProShares Ultrashort Silver (NYSEArca: ZSL) goes up twice the value that silver goes down, and there were a few genius institutional investors out there who used ZSL to this effect. Data Explorers numbers show that funds that lend their assets increased holdings in ZSL from 200,000 shares to 1.55 million shares between April 18 – May 3, making a handsome return as silver fell.
As the situation calms down, the scores on the doors are as follows: SLV is down over 25 percent and we hear some leveraged funds are down almost three times that amount, whereas ZSL is up more than 70 percent. Meanwhile, back in the smooth and steady world of single-stock investing, Fresnillo is down around 7 percent. Some would argue the ETCs have created a wealth of choice.
We also need to remember that ETF providers simply offer a security that tracks an index. If this index swings wildly during moments of volatility, it is the index providers’ issue rather than the ETF. Conversely, it is the ETF’s fault if the instrument has a big tracking error with the index.
This is why we should expect to see more indexes that take a sampling of the constituents in a given benchmark, such as with the new Nasdaq 100 Data Explorers Optimized Index (Nasdaq:NDXOPT). The sampled version of the Nasdaq-100 eliminates hard-to-borrow names, thereby making it an easier index for firms like Source and ETF Securities to create. That, in turn, will result in cheaper costs for all, while retaining the performance of the original index.
As ETFs and ETCs have gathered more assets, questions are beginning to increase right along with investor interest. Many people are questioning the products’ composition, efficiency and ability to track their underlying indexes. They are asking whether the counterparty selection is probing in the right areas, and whether greater transparency will make the ETF industry stronger in the long term (assuming the providers continue to respond with more transparency).
Regulators need to consider that indexes are, and always will be, quirky. For instance, did you know that Switzerland’s main index basically reflects the movements of a single massive company, Nestle, which makes up around 20 percent of the index, as revealed in the comments posted to a lively IndexUniverse debate. The FTSE 100 is not a barometer of the U.K.’s economic health—it tells you how well financial and resources companies are doing.
Talking resources, the London market will be biased even further toward commodities with the upcoming IPO of Glencore (market cap expected in the $50 billion to 70 billion range). If you don’t have the stomach to invest directly in ETCs, perhaps an investment in the experts might do the trick?
ETFs And Shadow Banking
As we pointed out last week, ETF issuers have given quite diverse responses to the three ETF-related studies that came from regulators in quick-fire succession in the middle of April. A roundtable of issuer comments on the same subject in ETFM also suggests some confusion about how to respond to regulators—or even what the underlying concerns are.
There are some common themes that come out in the responses, nevertheless: ETFs are regulated funds in Europe and are compliant with the existing regulations, said one issuer; active funds often engage in the same activities (of securities lending, for example) and are not subject to the same scrutiny as is currently being applied to the ETF market, said another; the gross level of derivatives exposure in ETFs is not that meaningful when compared to the overall size of the bilateral derivatives market, a third reply suggested.
At the same time there seems to be an acceptance that further regulatory guidelines on disclosure are on the way. Indeed, the ETF industry has arguably been pre-empting any such new rules. Take, for example, the decision by several swap-based ETF issuers to start publishing details of their collateral baskets over the last year.
On the other hand, there are still several underlying activities in the ETF market that remain either completely or substantially opaque to the end-investor: securities lending practices; collateral management policies in synthetically replicated funds; and the contractual details of the total return swaps themselves.
But, more fundamentally, what’s driving the regulators to make public their specific concerns about the ETF market?
A clue comes in a speech given by the Bank of England’s deputy governor, Paul Tucker, last year, entitled “Shadow Banking, Financing Markets and Financial Stability”.
Defining shadow banking as “those instruments, structures, firms or markets which…replicate the core features of commercial banks: liquidity services, maturity mismatch and leverage”, while existing outside the official system, Tucker names particular categories of the shadow banking system that might pose threats to broader financial stability: money market mutual funds; finance companies; asset-backed commercial paper (ABCP) and structured investment vehicles (SIVs); securities dealers and particularly their prime brokerage units; securities lending; and the residential mortgage-backed securities (RMBS) and repo markets.
It appears that ETFs have just been added to Tucker’s list.
Why? Note the emphasis in the FSB’s paper from two weeks ago on the possible use of ETFs as “collateral in a long chain of secured lending and rehypothecation [which] may create operational risks and contribute to the build up of leverage”. Observe the particular focus in the working paper on ETFs from the BIS on banks’ capital structure, liquidity coverage ratios and the possible use of swaps in synthetic ETFs to create a maturity mismatch in banks’ asset/liability management. Under current rules, banks may be able to account for their ETFs as a source of stable, longer-term funding, says the BIS, while in fact ETFs offer investors the ability to withdraw cash at will. There’s an implicit and potentially risky maturity mismatch, in other words.
So it seems to make sense to see the latest pronouncements by regulators on the ETF market as part of a much broader campaign from them to analyse, understand and ultimately rein in the shadow banking system. Requiring banks to allocate higher risk weightings to non-standard sources of funding, such as ETFs, could, in turn, undermine the business models of some issuers, as could restrictions on other activities, such as securities lending.
That regulators are serious in their intent to impose new constraints on the shadow banking sector is without doubt. Although it had nothing to do with ETFs, the U-turn imposed on Barclays this week—the bank was forced to repurchase Protium, a special purpose vehicle it had spun off in 2009 to hold toxic assets, after Basel III rules made the bank set aside more capital to back the loan it had made to the SPV—is a tell-tale sign that the rules are being tightened up.
Ultimately, regulatory pressure of this type may force a long overdue consolidation of European ETF ranges. Perhaps we’ll get some slimming down of those 50 European listings of funds tracking the Euro Stoxx 50 index after all.
Attack On ETFs Includes Securities Lending
“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.
The views expressed by those blogging are for informational purposes only and should not be construed as a recommendation for any security.