ETFs, UCITS and the Asian mutual funds market

At the end of July 2012 there were, in Asia ex Japan, 400 ETFs/ETPs having their primary listings in the region with a total of 518 overall. With respect to the primary listing ETFs this amounted to an AUM of US$69 billion offered by 88 product providers over 14 exchanges.  The compounded annual growth rate (“CAGR”) has been 31% over the last 10 years and year to date is up 21.8%.

To view this then in a global context the CAGR over the last 10 years has been 26.6% and this and the year to date growth of 12.9% reflects how well the Asia ex Japan region is performing. Globally the industry has 4,722 products and 9597 listings. These products represent assets of US$1.72 trillion from 203 providers and available across 54 exchanges.

For non local products the preferred vehicle to access the Asian markets has been UCITS funds which are funds offered in member states of the EU and through harmonisation to the requirements of the Directive allowed then to be sold throughout the EU on a passported basis.

For product promoters the relative ease with which EU member states’ funds authorised as UCITS may be passported for distribution into other EU member states has been a considerable benefit since the permitting Directive was first introduced in 1985.

In the intervening years the badge of quality, both in terms of retail investor suitability and inherent safeguards, of the UCITS brand has seen its appeal grow beyond Europe and it is now widely acceptable for registration – and in the case of ETFs listing –  in jurisdictions in Latin America and Asia and beyond.

The success of the UCITS story has extended to ETFs with Asia a key target growth market for several local and international providers.

The development of UCITS over the years has seen a move from a conservative range of permitted investments and policies to more sophisticated strategies. These so called “Newcits” have caused some concern in Asia and beyond with local Regulators increasingly scrutinising these funds that use more sophisticated strategies in their investment policy to achieve their investment objectives.

There have also been some concerns around the UCITS ETF brand which concerns may have been amplified by the vocal debate around physical and synthetic models of ETF replication and to which supra national bodies like the Financial Stability Board, the Bank of International Settlements and the International Monetary Fund contributed with systemic risk concerns allied to the investor risk concerns aired at local regulator level.

In the EU the pan European regulatory body ESMA engaged in a wide-ranging consultation on ETFs and UCITS issues culminating in a recent publication of Guidelines around ETFs, which are binding on promoters. While the replication methodology is not a requirement for inclusion in the ETF name it must use the label “UCITS ETF” to distinguish itself from the effectively unregulated exchange traded notes and exchange traded commodities and it must provide a full description of the replication method in the Key Investor Information Document (“KIID”). This approach contrasts with the more rigorous requirement of the Hong Kong SFC that synthetic ETFs must identify themselves as such and use an asterix to signify their replication style.

The KIID for all UCITS will serve as a valuable information document for investors but with regards to ETFs specifically it will in addition to the replication method require effective disclosure around securities lending activities of physically replicating funds. It will also require details of any factors that might cause the fund to deviate from its index tracking which in physical funds will require disclosure of the impact of sampling strategies and rebalances of the index while for synthetic funds would require disclosure of the swap spread  – not currently required to be disclosed. The funds will also have to publish a predicted tracking error and explain any deviations from the published predictions in the annual and semi-annual accounts.

Interesting and all as the ESMA Guidelines are the more interesting development from the perspective of the Asian Regulator may lie in the European Commission Consultation document published the day after these guidelines and seeking to address “Product Rules, Liquidity Management, Depositary, Money Market Funds, Long Term Investments”.

Opening the consultation questions with the blunt interrogation – “Do you consider there is a need to review the scope of assets and exposures that are deemed eligible for a UCITS fund?”- it is apparent  that some of the more sophisticated strategies permitted under UCITS are causing concern to European as well as Asian Regulators.

We are in an early stage of the process and many promoters will be attached to the distribution capability of their “Newcits” – though that term itself is almost a forbidden word for promoters now, such are the risk connotations – and there remains a valid argument that it is surely preferable that retail investors seeking access to more sophisticated strategies should have them within the wrapper of a well regulated structure. With this is mind it is possible we may see the reintroduction of the complex/non-complex designation for certain UCITS meaning that those which use leverage or complicated strategies may be limited in terms of their distribution to the advised investor. Certainly such a labelling might make it easier for non EU Regulators to identify to which funds seeking to access their market they should focus the most attention.

The focus on ETF regulation and reform should not detract from the fact that ETFs structured, as funds are already highly regulated vehicles with a focus on suitability and with the in-built protections that are to be expected in investments deemed suitable for retail investors. To that end debates around styles of replication, levels of disclosure and suitability of exposures should be seen in the context of raising an already high bar of excellence further. In ETF, in UCITS and in other regulated fund space it will be a well-attended and valuable debate to the end investors ultimate benefit.

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Active ETFs

The credit crisis reaffirmed the idea that what begins in the US often ends up in Europe and, with our Eurozone crisis an added twist, the truism that when the US sneezes Europe catches a cold.

Flippancy aside, in the world of ETFs, the synthetic versus physical debate has been largely avoided in the US. with the March 2010 moratorium of the SEC on exemptive relief for ETFs wishing to make significant investments in derivatives.

I suspect though the original pattern for ETF development in Europe to mirror the US will be repeated when it comes to so called active ETFs and the recent surge in filings in the US with over 20 recent filings with the SEC.

I have commented recently around the definition problems when it comes to active ETFs and the recent ESMA guidelines have been helpful in moving to clarify. They state it is an ETF “ the manager of which has discretion over the composition of its portfolio, subject to the stated investment objectives and policies (as opposed to a UCITS ETF which tracks an index and does not have such discretion). An actively managed UCITS ETF generally tries to outperform an index”. The guidelines go on to require promoters to make this fact clear in the prospectus, KIID and marketing documentation including “how it will meet the stated investment policy including, and where applicable its intention to outperform an index”.

On the face of it, these definitions leave open the possibility for a provider to bake an active methodology into an index which might range from a sampling strategy designed to outperform, to a more stock selective style screening methodology both of which strategies are already in use, particularly by fixed income funds.

The guidelines are quite prescriptive however on the use and construction of financial indices beyond the previous simpler formula that they be diversified, representative and published. Any index now ,that seeks to code an active strategy into an index will be forced to reveal the “secret sauce” in the requirement that the index constituents and their weightings must be published and freely available – a welcome requirement which even for some pure passive providers is going to raise some issues with the reluctant index provider.

It is the preservation of the “secret sauce” that raises some concerns around the question of ETFs that do not seek to replicate an index. I previously listed the characteristics of an ETF which included publishing an indicative NAV (iNAV) which lends itself to the liquidity of an ETF ensuring a tight spread of trading around the NAV.

The original ESMA consultation paper that lead to the guidelines suggested a requirement that the policy regard portfolio transparency be published with disclosure as to where this information and the iNAV “if applicable” is available. The Securities and Markets Stakeholder Group in their comments appeared to endorse that though were more bullish about an explicit statement stating it was not aiming to track an index. In the final guidelines however, ESMA noted that “some respondents questioned the merit and appropriateness of disclosing to investors how the iNAV is calculated as they will buy and sell units or shares at the offer price on the exchange.” The requirements as to iNAV therefore did not make the final guidelines even in the “if applicable” form.

This matters when we consider how the pricing of ETFs occurs and how it is kept in line with its NAV. Product structures who have looked at how to build a hedge fund ETF know that one of the issues that arise is the difficulty in selling a UCITS fund whose underlying constituents of the hedge fund index may not open as frequently as the ETF. This pricing disparity is reflected in the price and to be economic generally may require an in-house model where the swap provider, promoter and hedge fund index constituents are of the same group. Alternatively these hard to price models may operate a NAV+/- model where a spread for primary market creation is wrapped around the fund. Any profit or loss on this accrues to the fund with the managed hope it will balance over time.

Active funs being run on a vertically integrated model or through a non-transparent pricing model does not seem to be a progressive step and appears inconsistent with the transparency that underpins the original concept of an ETF.

The SEC in examining active fund filings will assess the ways in which a degree of transparency is introduced – be it full transparency in the hard to copy bond funds or proxy portfolios aiming to mimic the performance of the true underlying’s.

In Europe the promoters who might see a benefit in keeping the regulation on this small sector of the ETF industry high level would do well to reflect on a cautious approach to product development lest the simple message of ETFs that has lead to such growth compared to traditional mutual funds is undermined. The US ETF industry avoided the physical versus synthetic cold. An equally cautious approach to developing active ETFs is not without merit.

 

ETF Providers – cost cutting and market share

The Global ETF market is dominated by three industry giants, iShares, State Street and Vanguard holding 38.7%, 17.6% and 12.4% respectively. This top three positioning and the fact that the top 10 products – largely within the stable of these providers – account for 90.6% of the total show a remarkable stability at the top of the market.

When we look to the regional provider tables we see that iShares is the firm that has established a significant foothold in all the regions but it is notable that the other giants of the industry are ramping up their global ambitions and challenging iShares on its home turf with Vanguard taking a further 2% of the market while iShares declines to 40.7%.

It is likely therefore that we will see some movement in the relative size of the industry heavyweights and while performance, liquidity and fund structure will continue to be key, price will be an increasingly important component.

The physical v synthetic “war” that has raged in the European ETF market over the last 3 years has benefitted the physical providers though the moves by the synthetic providers to adapt their models to address regulatory concerns and their effective highlighting of the counterparty risk in physical funds securities lending activities means that the parties might now be seen to be fighting on a level playing field.

The U.S. regulators do not however permit full replication synthetically so the driver for competition has revolved around performance and more importantly cost. In the cost model Vanguard is typically significantly less expensive while their ownership model – they are owned by the funds – means they do not have the shareholder ownership pressure that mitigates against pricing discount model. The fund flows

It is a truism that in economic terms what begins in the U.S. ends up here – though we should be proud of our own home-grown Euro crisis – and it is likely that the pricing war we see being fought in the US – will spread to Europe.

For the investor then it is important to look at the cost of investing in an ETF.

ETFs, underpinned by their principles of transparency, are far ahead of their mutual fund rivals in disclosing total cost of ownership with a flat fee rate the norm, from which all administrative costs are deducted and a factory gate pricing model that rules out intermediary commission.

The management fee charged by the promoter is not however the sole consideration for the investor who could more meaningfully look to the total cost of investing in the product. This figure should equate with the performance difference between the fund and the index so for example to refer back to the US example we saw huge outflows from iShares EM into Vanguards equivalent offering which was both cheaper in terms of the management fee and performed better so that the implicit costs of investing against the anticipated return was significantly lower for the lower management fee fund. This of course may not always be the case so a lower management fee synthetic fund may have significant costs associated with the cost of the swap while the low cost physical fund may have higher rebalancing costs. The investor in considering the implicit costs can also consider the impact of tracking difference which is broadly speaking lower in synthetic funds and higher in physical especially for emerging markets and more highly optimised funds and also the positive returns that securities lending can deliver back to a fund.

Finally, for the secondary market investors it is important to to consider the spread on the investment itself and ensure the optimal execution point.

So, for the investor and understanding of total costs of investing in the fund is key. For the industry the experience of the US suggests that as the large providers grow in their global ambitions the stage is set for increasingly competitive pricing – a development likely to benefit the end investor.

August 2012

Exchange traded products – the need for classification – June 2012.

It is arguable that the genesis of the concern around ETFs lies both in their rapid growth and more significantly the concerns that first emerged around the security of uncollateralized exchange traded notes at the height of the credit crisis when the issuers and backers of these notes, principally investment banks and insurance giants, wobbled in the aftermath of the Lehman collapse.

The irony remains that in the EU the bulk of regulation attaches to the already highly regulated funds sector with the various participants arguing, over the past 4 years, the incremental levels of excellence in investor protection above an already high mark of regulation, while the effectively unregulated market will recover the ground it lost at the then height of the crisis without really participating in this debate. As memories of counterparty exposure fade, investors will one day return to quick to market investments where neither the exposure nor the protections in its delivery might be considered suitable for the unadvised retail investor. The continuing uncertainty in the Eurozone, with the attendant contagion risk for those issuer banks, means that it is likely that counterparty risk for private issuers – let alone public ones – will remain a real and present concern for some time.

Notwithstanding that focus, the regulators are mindful that something clearly needs to be done in this area as a long term solution. From the initial report of the Financial Stability Board to the European Securities and Market Authorities Consultation Paper on ETFs they have opined that some level of regulation or distinction around non fund exchange traded structures will be required. It is simply not enough, as some providers have done, to suggest it is sufficient that the investor has access to the prospectus or offering document of the note or debt security structure when the current level of regulation allows the retail investor to access these often complex, high risk or low safeguard products without either seeing that prospectus or being advised as to the nature and risk of their investment. This situation is not optimal, but perhaps acceptable, with regard to funds and some of the exposures they offer, but is clearly undesirable with respect to non fund structures.

In our view the progress in MiFID and PRIPS may – and hopefully will – ultimately level the playing field so that investors in funds and notes will at a minimum understand better the distinction and/or have restricted product offerings and/or ( and as a probability likely)  have the suitability concerns addressed at the point of distribution through prohibition on access or access on the foot of expert advice only – the free for all through the unadvised brokerage account may end.

European Directives and their transposition into Member State laws take time and a quick win might be to address the labeling confusion around the offerings within the exchange traded universe so that the investor at least knows what he needs to think about. This is a point it might be imagined – wrongly as it happens – that promoters of funds might be in agreement on as clearly the promoters of the non fund offerings will benefit from investors thinking their products are on the same level as funds.

Broadly, it could be proposed that an investor might be advised to think about all exchange traded offerings under the generic term exchange traded exposures. The benefit of such a term is that it does not, unlike some terms in loose usage, imply the nature of the product and more particularly its regulation. It is a term more akin to the nature of the investment risk assumed – a concept which is generally easily understood.

The second limb then is to consider how that investment risk is delivered to you as the investor and what additional risks you assume. Clearly then there is a need to distinguish between ETFs and all other exchange traded exposures – be it a generic term such as Exchange Traded Products or a labeling of the individual product types – ETNs, ETCs, ETVs etc. For the investor however, the point is that once they are made aware that their exposure is outside the highly regulated world of both their investment and their structural protections in the funds world they can understand the effectively unregulated nature of their investment and proceed with caution. Non fund products should never use or be loosely associated with the term “ETF”.

The loosely defined nature of what an exchange traded exposure can be means there is no right answer here but there are wrong intentions that muddy the waters as to the risks undertaken. The industry could do well to seek an agreed solution in advance of a necessarily imposed one.