Fund Complexity, Chickens And Eggs

What’s being talked about at the Inside ETFs conference in Florida?

I’m reporting from the annual “Inside ETFs” conference in Boca Raton, which has provided a welcome break from the cold of Northern Europe in January.  It’s been an excellent event so far, with thought-provoking discussions and plenty of audience participation.

Index Publications will be running the first European “Inside ETFs” in San Sebastian, Spain, later this year. Keep an eye on the website for further information!

A couple of themes have recurred in the panel discussions here – there is clearly still some confusion amongst investors about the return profile of leveraged ETFs (whether leveraged long, or leveraged short), which can diverge substantially from a simple multiple of the period return of the underlying index, due to the unpredictability of the effect of daily rebalancing and daily compounding of returns (here’s a great description of the problem). While the double- and triple-leveraged ETF sector is nowhere near as developed in Europe as in the US market, have ETF issuers done as much as they need to explain this?

When combined with the state of the markets, the increasing complexity of tracker products is causing plenty of serious reflection. A financial adviser seated next to me this morning said, “The presentations this year are a lot more sobering than at last January’s conference. Though the discussions have helped me – I feel I know now which questions to ask.”

During the panel discussion on the ETN market that I moderated yesterday, Lloyd Raines of RBC advised the audience to read the prospectus for all exchange-traded products that they might invest in, “in case you miss footnote 7 on page 73.” Philippe el-Asmar of Barclays Capital said in response that product issuers would love to issue one-page descriptions of their notes or funds, highlighting key features, but that directory-sized issuing documents were simply a fact of life under the SEC. Both Lloyd and Philippe are right, of course – but you wonder how much protection the regulators’ rules have actually ensured for investors, given the events of the last year. Unfortunately, this seems something that won’t change in a hurry, at least not in the direction of greater simplicity.

In fairness, the ETF industry has still done a good job in explaining itself to investors by comparison with several other sectors of the funds sector, but there is clearly no case for complacency.

The other discussion topic that has come up several times during the conference is the question of the discounts to NAV that appeared on corporate bond ETFs in October (reported on by Murray Coleman here). A number of product providers have made the assertion that, far from malfunctioning during the peak of the market stress last year, ETFs were in fact trading much more actively than the underlying corporate issues themselves; in effect, ETFs were the main price discovery mechanism for corporate bonds at the time and that it was the index calculation mechanisms that failed to reflect market reality. In other words, the discounts to NAV that appeared were more apparent than real, and that the indicative NAVs (iNAVs) and indicative optimised portfolio values (IOPVs) were the source of the inaccuracy.

This, of course, raises all kinds of interesting questions about the reliability of index calculations when markets become illiquid. At the very least, it reminds us that the process of index compilation is not perfect, however systematic and well-thought-out the index design is. But there’s a philosophical question as well, a paradox along chicken and egg lines. If ETFs were created to track indices, do the indices themselves need to be reexamined to ensure they are tracking the ETFs?

[yasr_overall_rating size="large"]
error: Alert: Content is protected !!