AFR: The troubling future for ETFs

Australian Financial Review, Smart Money, October 30 2010

For years, exchange-traded funds (ETFs) have been marketed on their simplicity. In 2001 State Street Global Advisors launched its SPDR S&P/ASX 200 fund, with a pitch based on making life easy: exposure to the whole index, by buying a single stock, with a very low fee.

And that’s the way the industry has stayed for most of the last 10 years. But like all markets, ETFs are evolving, and recent product launches suggest the market is already moving away from its straightforward roots. If it continues to do so, it will move into territory where the products are no longer feted for their ease of use and transparency, but causing alarm for their opacity.

We’re not there yet. An AFR study of all available ETFs in Australia shows none that cause any significant cause for concern today. Indeed, they are a cheap, transparent and welcome method of diversifying exposure in a portfolio. But elsewhere in the world, where the industry is older, they’re not all as widely loved as they used to be.

So where are we up to in Australia? For years, State Street had the market to itself. Its SPDR products illustrate much of the appeal of passive ETFs everywhere. They hold most of the underlying stocks in an index, and so trade more or less exactly in line with it. At any given moment you can find out exactly what its holdings are, and because it’s traded on the ASX, it is subject to the same disclosure rules as any listed stock. Over the years State Street added other, similar vehicles: one for the S&P/ASX 50, and one for the S&P/ASX200 Listed Property Index.

In recent years, other providers have moved in. iShares, now owned by Blackrock, has launched a series of international ETFs so that the same principles of the State Street product in Australia can be applied to global shares. There are now 19 iShares products, from global equity and emerging market indices to single-country vehicles mirroring the performance of indices in China, Korea and Taiwan. “They represent a low-cost, liquid and transparent way to invest in the global equity market,” says Tom Keenan, director for retail at iShares. “We see financial advisors use them as building blocks to create global equity portfolios and implement a long term strategic asset allocation for their clients.”

Other groups have looked for different opportunities. Australian Index Investments listed six ETFs earlier this year, each one tracking a different sector of the Australian market: resources, metals and mining, energy, industrials, financials, and financials ex-property trusts. These are designed for people who might, for example, decide they have a positive view on resources but don’t just want to be exposed to BHP and Rio Tinto.

Another provider, ETF Securities – which, like State Street and iShares, produces these products internationally – went for something subtly different, called exchange-traded commodities, or ETCs. These are backed by physical metals: gold, silver, platinum, palladium, and a basket of precious metals. All of them include the word “physical” in their formal title to indicate that they are backed by real metal – an important distinction, as we will see below.

And Vanguard Investments, best known in Australia for its passive managed funds, has created ETF versions of three of those funds, both domestic and international.

Up to this point, everything is simple: though they cover different countries, assets and market sizes, they are all passive products that seek to do nothing other than deliver the performance of an index or commodity at a low cost.

And after a slow start, ETFs have boomed. By September 2010, there were 33 listed ETFs in Australia with a combined market capitalization of A$3.94 billion – up almost 40% on the A$2.83 billion a year earlier, which itself was up 158.1% on the A$1.095 billion in September 2008. Part of the reason for the boom is that they have been embraced by financial planners. State Street used to complain, reasonably, that planners ignored ETFs because they didn’t pay them a trail fee. But since regulatory change has prompted a major shift from commission and trail-based income to fee-for-service type financial planning, that’s become less of an issue, and planners find them a cheap and easy way to do what they need to with a client’s portfolio. Self-managed super funds, in particular, have embraced them.

Then, in May, Russell Investments launched what it called “the next generation ETF in the Australian market”, called the Russell High Dividend Australian Shares ETF. This was crucially different to the products that had gone before, because it was based not on a widely known index but a customised one built by Russell itself, and skewed to companies expected to pay above average dividends. It is comprised of blue chip companies with a history of paying dividends, dividend growth, and consistent earnings. Launching the product, the managing director of Russell’s global ETF business, James Polisson, said that “no other ETF provider has the index and portfolio construction expertise” in Australia.

Portfolio construction? What does that have to do with passive ETFs? Well, Russell was not alone, because last month State Street joined it with a new launch of its own. The SPDR MSCI Australia Select High Dividend Yield Fund does pretty much the same: it’s based on an index invented to a customised specification by MSCI, the worldwide index provider, and it invests in high dividend yield companies who are likely to sustain that approach.

The crucial difference between these ETFs and the ones that went before is that they are making a call on the right sort of stock to be in an index, and that starts to sound rather like active management. In fact, both products charge very low, passive fees – State Street 0.35%, and Russell 0.46%. But they are what is known in the industry as “rules-based” products.

There’s nothing wrong with these products: both providers argue that they service a need for stable yield and are particularly suited to those approaching retirement. “There is a clear opportunity for a strategy that can deliver a reliable, tax-effective, sustainable high income from equities,” says Rob Goodlad at State Street. “I think people want an alternative to the traditional models they have used for their income stream in retirement.”

They are still backed by the underlying stocks, and they are still completely transparent, with the full portfolio available on the Russell and State Street web sites respectively. It is possible they might underperform the broader market, but provided an investor understands exactly what their exposure is to, that’s part of the risk of an investment.

But the new funds are interesting when seen in the context of what’s happening elsewhere in the world. In June, the Bank of England – which gets listened to these days, having correctly flagged concerns about collateralized debt obligations (CDOs) in July 2006, well over a year before they set the global financial crisis in motion – issued its regular financial stability report, and devoted a lot of space to scrutiny of ETFs in the British market.

The Bank stressed that ETFs do offer a number of advantages to the market, including the fact that they give access to a wide range of financial instruments in a liquid form to a much larger slice of the population that would normally be the case. But it also raised a number of concerns, saying ETFs “also potentially bring some risks to the financial system, and these will need watching.”

The Bank is chiefly referring to products that don’t yet exist in Australia, but are likely on their way. One is the leveraged ETF. According to the Bank of England, these account for only 3% of the ETF market, but because the turnover in these products is much higher than mainstream ones, they account for about 20% of their daily UK turnover.

Another is the ETF that doesn’t actually hold the assets it gives exposure to. Some use derivatives such as a total-return swap. We asked every ETF provider in Australia directly if all of the funds are underpinned by holdings in the relevant securities or commodities – all of them said they are. But elsewhere in the world, this derivative approach is quite common, and as the Bank of England points out, these bring complexity, counterparty risk (what if the bank you’ve struck the swap with gets into trouble? It happened with Lehman Brothers) and no longer have the same transparency you associate with normal ETFs.

There is another reason to be wary of derivatives underpinning ETFs. Take oil. There are no oil ETFs sold in Australia now, but when one inevitably arrives, it’s unlikely to be backed by real barrels, but probably by futures contracts as is common in the US. Futures can trade at a different level to the market they are linked to, which can create opportunities for other traders to drive them up or down for profit, at the expense of ETF holders: hence one recent instance when an oil ETF declined in value in the US as oil prices themselves were going up.

ETF Securities, the only seller of commodities-backed ETFs in Australia today, is at pains to point out it does not use these derivatives, but is backed by real metals held in a vault. “Our ETFs have no counterparty or credit risk behind them,” says Nigel Phelan at ETF Securities. “If we were to fall over, along with our custodian – which is HSBC – the investors would have 100% recourse. The physical underlying is available at all times to the investor as a security. You’ve seen the whole complex structured product industry implode over the last 18 months so there is a real growth in physical-backed products with collateral behind them.”

The Bank of England also looked at a practice becoming more common in England in which providers, having bought the stocks that underpin an index, then lend those stocks out – a practice known as securities lending – in order to bring in more money and lower the fees. It was concerned about a lack of transparency among providers doing this. This is one trend that can take place in Australian ETFs: both State Street and iShares, for example, can do securities lending, which in turn allows other investors to short the index.

The Bank also raised questions about liquidity – the ease of trading the funds – and generally about confusing, increased complexity. “One risk is that the benefits of ETFs become outweighed by complexity, opacity and contingent risks,” the Bank concluded. “Swap-based ETFs have already come in for some criticism for their complexity, while a number of ETFs are not fully transparent about the risks arising from securities lending and counterparty risks from derivative exposures.”

One other criticism, not raised by the Bank of England but talked about elsewhere, is that ETFs can exacerbate market bubbles through their sheer ease of use, and can cause problems when those bubbles burst, although in fairness that is really just ETFs reflecting broader market sentiment.

So where are we going next? More complex ETFs are certain to appear here in time. “There’s definitely a place for them in the market,” says Annmaree Varelas, CEO of Australian Index Investments. “US traders like the products and probably in Australia traders will like them as well. Where there could be some investor confusion is with the expectations of the performance of those ETFs – and that’s where there needs to be a greater level of labelling, especially for mums and dads who may invest in these. There must be enough disclosure around them with risk mitigation strategies put in place for them.”

Will AII be the group that brings them to Australia? “We’ll probably look at them down the track, but we’d like another issuer to put one out first so we can have a look at how well they go,” she says. “It’s not something we would consider at this point in time.”

Keenan at iShares says swap-based ETFs are “not necessarily a bad thing, it’s just that investors need to understand what risk they are taking.” He thinks they will be a while coming to Australia. “The market is only just taking off here. The local investment community are still getting their heads around how these broad cap-weighted index ETFs work, let alone an active or an inverse or leveraged ETF.”

Most providers in Australia say they’re in no rush to move towards the types of ETF that are causing concern elsewhere. Goodlad says State Street wants to do more in Australian equities, and that its next offering is unlikely to be rules-based. “This [the new fund] was probably unique because we had clear demand from planners and stockbroking groups for something that would pay perhaps 1% over the prevailing ASX200 index,” he says. “We thought it was a good fit for baby boomers getting closer to retirement. But I think we’re going to stick with the well known benchmarks for the moment, we’re not looking at anything too exotic.”

“It’s an interesting fulcrum we’re at, where people are talking about leverage and swaps and shorting and all those words that raise eyebrows,” he adds. “But as far as we are concerned in Australia the integrity of the strategies that we run are rock solid.”

Russell, having started out with a rules-based ETF rather than a more mainstream one, is likely to drive innovation: it plans eight to 10 products within the next 18 months, including some for institutions and “factor-based products that can be used for portfolio construction and risk management purposes,” says Amanda Skelly, director of ETF product development at Russell Investments. Leveraged ETFs will depend on the views of ASIC and the ASX, she says; and if they come, “it is absolutely imperative that simple, plain English style disclosure around the risks involved is adopted by ETF product issuers.”

“Swap-based ETFs are designed for sophisticated investors as they can be risky if not properly understood,” says Skelly. “So there definitely is a role for them, but they should be used prudently…in most instances, Russell believes that a simple, real asset based approach is more suited to a retail investor,” although in some cases derivatives might be useful for something like currency management.

All, though, expect the market to grow, with more products and more competitors. Goodlad expects the ETF market to grow to around A$25 billion in the next three to five years. And it would be a surprise if ETFs did not grow to embrace more asset classes, such as bonds and more commodities, in the near future. They’re on their way.

BOX: Tracking the market?

We looked at ETFs from four of the six providers in Australia to see if they do what they’re meant to. The Russell and AII products are too recently launched to give meaningful results.

SPDR S&P/ASX 200: Pretty close, as one would expect: it holds 83% of the underlying market. In the three years to August 31 2010 it returned -6.9%, while the index returned -6.95%. In the five years to that date, the fund returned 4.23%, the index 4.24%. Spot on.

VANGUARD FUNDS: There’s some variety here. The Vanguard US Total Market Shares Index  ETF returned 1.31% in the year to September 30, exactly the same as the underlying index. But in the other two funds there was some divergence: the Vanguard All World ex-US Shares Index ETF returned -1.99% when the index did -1.54%. And its Austrlaian Shares Index ETF returned 0.41% when the index did 0.65%. But here’s the thing: these are all reported after management costs, which account for the latter two variations, but raises the question why the US fund mirrors its index so precisely!

iSHARES: The further you go into multiple and volatile markets, the harder it becomes to track the benchmark accurately, and this shows in some iShares numbers. It MSCI Emerging Markets fund is down 2.68% in six months to June 2010, for example, when the index is almost even at 0.09% – not a good outcome, although it is important to note that iShares report its performance after fees. Looking over the longer term, however, smooths out some of the oddities: over three years the fund is down 2.62%, the index 2.35%. Over five years the fund is up 9.32%, the index up 10.44% which, with fees considered, is much closer to the mark.

ETF SECURITIES: This is the one with the most marked divergence. According to the manager’s own web site, in the year to August 31, gold was up 30.62%, silver 31.4%, palladium 74% and platinum 22.67%: in all cases that’s the metal itself. Yet over the same period the relevant ETFs went up gold 20.36%, silver 18.43%, palladium 62.58% and platinum 16.39%. How can this be, when all of them are backed by physical metal held in a vault by HSBC? The answer is the currency. Those metal performance numbers are all in US dollars, but the Aussie dollar has increased dramatically against it over the last year, neutralising the ETF performance.

BOX: TALKING HEADS

We asked five ETF providers where they thought the market was heading next.

“If you look at Australia compared to the States, I’d say we’re at least five years behind where they are. A lot has been written about active and leveraged ETFs but they haven’t raised much money. Intellectually they might make some sense but you’ve got to make sure the market’s ready and we have not convinced ourselves that that’s the case here. We’re at stage one.” Rob Goodlad, State Street Global Advisors.

“There are a lot of providers who are seeing ETFs as the next frontier of growth so you are going to see a surge coming into this area, with a whole landscape of asset classes and different exposures. But the real focus for any new product is that people want little or no counterparty risk.” Nigel Phelan, ETF Securities.

“You’ll definitely see more strategy-based ETFs than the passive, index-style products going forward. It’s giving investors a way to generate a better than market return. You may see leveraged ETFs come to market in the next 12 months.” Annmaree Varelas, CEO, Australian Index Investments.

“The critical elements for an ETF are transparency and liquidity. ETFs based on a clearly defined index constructed with a clear set of rules, that are transparent and can be easily communicated to the market, can work quite well. But a true active ETF with bottom-up stock selection is more difficult: no portfolio manager is going to want to send their holdings out to the market each day and that’s what’s required with an ETF.” Tom Keenan, iShares

“We believe that there is a lot of scope for new ETF product development beyond the pure market cap style in Australia and we expect to see significant growth in this area. Developments in leveraged and actively managed ETFs are likely. However substantial development in this space is still some time away.” Amanda Skelly, Russell Investments.

BOX: What’s What?

ETF: The simplest ETF replicates the performance of an index like the S&P/ASX 200. You buy and sell it like a share.

Sector ETF: Exposure to a sector of the market like resources.

International ETF: Exposure to a foreign market

Commodity ETF or Exchange-traded commodity: Backed by the performance of a commodity, like gold

Rules-based ETF: Based on a custom index filtered for, for example, high-dividend stocks

Active ETF: Unlike most passive ETFs, this one involves active management like a managed fund, but is still bought and sold like a share.

Leveraged ETF: One that uses derivatives to increase gains (or losses)