Cautionary tale
While the market for exchange traded products in Asia continues to grow, industry experts have highlighted areas of concern.
Exchange traded funds (ETFs) are growing fast globally. Net assets stood at US$1.5 trillion in April 2012, a slight decline in March caused by market moves rather than net outflows. Year to date assets increased by 13.1% and net inflows in April were US$2 billion.
The Asia Pacific Ex Japan market continues to grow, now featuring 350 ETFs listed in the region, part of a wider exchange-traded market featuring 458 total listings and US$60.3billion in assets. Year to date there has been an 11% increase in assets in the region. Fixed income ETFs have been the strongest performers, gathering US$510 million in net new assets of which US$380 million went into government bond ETFs, and US$56 million went into ETFs tracking broad/aggregate fixed income indices.
Commodity ETFs also experienced net inflows year to date, although ETFs tracking broad commodity indices saw net outflows of US$13 million – precious metals attracted US$59 million year to date.
Equity ETFs suffered net outflows of US$355 million, mostly from developed Asia Pacific equity indices which saw US$265 million net outflows, as well as emerging market equity ETFs losing US$82 million.
Dark history
For some two decades, ETFs enjoyed seemingly unstoppable progress, with the features inherent to the original ETFs – transparency, liquidity, simplicity, diversification and cost efficiency in a fund wrapper with the ability to buy or sell any time during the trading day - presented this product as a serious challenger to the traditional mutual fund industry.
In 2008 however, the events following the Lehman Brothers collapse led to a cold wind blowing over this growth and revealed a dark problem at the core of the ETF industry – counterparty risk. Fears were amplified by the product promoters themselves who argued the detriment of one type of ETF offered by their competitors to the benefit of their alternative model.
For retail investors, the issue of counterparty risk had never really existed until the 2008 financial crisis. But the crisis ushered in a new era for the investment product buying public, an era of seemingly untouchable institutions collapsing or seriously wobbling. Such calamities moved the whole question of structural risk – the risk you assume through the method by which an investment exposure is delivered to you – on a par with that investment risk itself.
It was indeed ironic that the genesis of this concern lay in an exchange traded exposure that was far removed from the principles that underscored the original ETFs.
Exchange Traded Notes (ETNs) had become increasingly popular as a way of delivering products speedily to market, often at a discounted cost to the promoter, if not price to the investor, when compared against traditional ETFs. In addition these products allowed investors – institutional and retail – access to exposures that would not be permitted in a traditional fund. While the lack of regulation around investment risk might be understood by an investor – and it remains the case that there must be an issue over retail investors being able to access certain types of exposure on an unadvised basis through purchases on the stock exchanges – the fact that these products traded and settled like ETFs meant the crucial fact that the method by which these exposures were delivered to investors were effectively unregulated.
The net effect of this lack of regulation meant that the traditional protections implicit in fund regulation – segregation of assets, diversification of investment exposures, collateralization of exposures and independent oversight – were simply not present. While the promoter might argue this lack of regulation was disclosed in the prospectus of the note this was of cold comfort to the stock market purchaser who may have never even had sight of that document and assumed his ETN or ETC was equivalent to an ETF rather than materially different both in terms of that investment exposure and its deliverance and more particularly its protections.
In short, investors in the note were assuming investment risk and full exposure to the issuer.
Once this structural weakness in the market was revealed. investors and regulators stood back and took a hard look at all exchange traded exposures. Perhaps the key articulation of concerns was through the report of the Financial Stability Board in 2011, which identified four key areas of concern:
• the increasing complexity of exchange trade products such as inverse and leveraged exposures;
• concerns around securities lending in physically backed ETFs;
• concerns around synthetic ETFs especially where the swapcounterpart and the product promoter were part of the same entity;
• concerns around non fund exchange traded exposures such as the exchange traded notes discussed above.
The debate around these four areas of concern has been most pointed in Europe where it is possible to have physically replicating ETFs and those replicating using derivatives. In the US the latter product is not effectively permitted and equally it is clear there will be for the foreseeable future no further authorization of new leveraged and inverse ETFs as the regulator has been reviewing the use of derivatives in ETFs and mutual funds since 2010.
It is ironic though that the fears around exchange traded funds arose from the counterparty exposures in notes and while there may be counterpart exposure in synthetic products and in physically backed through securities lending it is within the context of highly regulated fund vehicles. The regulation of notes at a product level is largely untouched and it appears their accessibility will be limited though distribution channels.
The evolution of this debate will influence the growth of ETFs in Asia Pacific both in terms of the acceptability of UCITS and non fund structures in the various markets but also in the growth and increased regulation of the local funds industry. The expansion of the exchange traded exposures markets will continue.