Comparing Like With Like

ETFs are causing a furious debate. But that debate is really about the future of fund management

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.

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