Rob Langston looks at the exchange-traded product industry, which until fairly recently has been largely overlooked by financial regulators
 
The exchange-traded fund (ETF) industry has found itself at the centre of attention recently as financial regulators raised concerns over the structure of some products.
The International Monetary Fund (IMF) earlier this year highlighted the practice by European providers of using derivative contracts to replicate index performance, known as swap-based ETFs.
The practice has become more prevalent under the UCITS III regulatory regime, which the IMF said was now used by ‘nearly half’ of all European ETFs.
Swap-based ETFs can eliminate tracking error, but counterparty risk levels can be raised as the counterparty involved in the swap is the guarantor of the returns.
It is not the first time that the issue of counterparty risk has been broached. Questions were raised over single counterparty-backed products after the difficulties experienced by AIG – a counterparty to ETF Securities products in 2009. AIG-backed products saw their value plummet after the company had its credit ratings downgraded.
The IMF is not the only agency looking at the products. The industry is facing new scrutiny from the Financial Service Authority (FSA). In its first Retail Conduct Risk Outlook, the regulator highlighted the ‘high level of innovation’ of providers and the risks that consumers may not understand the difference between product types.
The FSA said it had ‘concerns’ over the products, and had ‘heightened’ its supervisory vigilance in the area. As the outlook will inform the regulator’s consumer protection strategy, providers may find themselves under renewed scrutiny. In its outlook, the regulator revealed concerns over marketing and promotional material. The industry would do well to heed the lessons of the Lehman-backed structured product investigation into marketing material, which put the sector under much scrutiny.
 
Exchange-traded fear
 
Alan Higgins, head of asset strategy at Coutts & Co, says the comments had come as a ‘surprise’, but argued that greater investor awareness of product structure was required.
Higgins says the wealth management specialist invests in both direct exposure and swap-based exchange-traded funds, adding that the company ‘didn’t see anything wrong’ with swap-based products as long as people were aware of the risks associated with the collateral.
‘It’s one of the fundamental rules of investing: make sure you know what you’re doing,’ says Higgins.
David Norman, founder of TCF Investment and formerly chief executive of Credit Suisse Asset Management in the UK, says the products have moved away from their original ‘simple’ structure since the UCITS III regulations were brought in.
Norman says that the principles-based regulation embraced by the FSA before the credit crisis – which led to accusations of ‘soft touch’ regulation – hadn’t worked and that greater moves could be made into a product-based regulatory regime.
 Norman says there may be other important regulatory issues further down the line with the next stage of MiFID (Markets in Financial Instruments Directive). Proposals could introduce suitability tests for investors in ‘complex’ ETPs for execution-only brokers.
David Bower, managing director at BlackRock-owned ETF provider iShares, says providers across Europe have used UCITS III regulations to create a new breed of products, offering index-like returns.
‘From our perspective, because of the size of the ETF industry, it is becoming a much more important part of the investment landscape, and it is only right that regulators take more interest in our sector,’ he explains.
Scott Thompson, co-head of European sales at ETF Securities, says the industry may move towards multiple counterparty structures to spread counterparty risk in order to satisfy regulatory concerns.
There can be little doubt that the industry is growing, which is likely to bring it ever more closely into the bosom of regulators. The exchange-traded product industry in the UK has grown exponentially over the past few years, with assets increasing by 49 per cent in 2010 to $93.4 billion. According to the London Stock Exchange, trading levels increased by 50 per cent in the first quarter of 2011, compared with the same period last year.
 
Risky business?
 
However, with risk having been the main talking point in the past couple of months, investors will surely be eager to know what the returns are.
As shows, FTSE 100-tracking ETFs vary in their ability to track the index, with the physically backed HSBC FTSE 100 ETF faring the worst. Despite it being the least exposed to counterparty risk, the ETF underperformed the index by £10 over the past six months based on an initial investment of £1,000, and by £35 over the year.
ETFs with the ability to invest in index swaps were able to give a much closer replication of the index over the time periods shown and with much lower costs.
There are numerous index-tracking open-ended funds available to investors that offer returns close to the index performance. However, the total expense ratio of these funds is at least treble that of the cheapest index-tracking ETF. In the case of HSBC, the asset management company’s open-ended FTSE 100-tracking fund offers better returns and a lower total expense ratio than its exchange-traded sister fund.
During March, the most traded London-listed ETF was the iShares FTSE 100, registering more than 30,500 trades, or 15.9 per cent of all trades. In comparison, the iShares MSCI Japan ETF – the next most traded ETF in March – saw just 7,975 trades, or 4.2 per cent of the total.
Elsewhere in the ETF industry, there is a large degree of evidence that the higher-risk strategies being looked at by the Financial Services Authority offer some of the best returns.
Unsurprisingly, leveraged exchange-traded products have shown the greatest levels of growth over the past year, particularly given their prevalence in the exchange-traded commodity industry.
ETF Securities’ Leveraged Silver product has shown great performance over the past year, with an initial £1,000 investment growing to £4,429. Other strong performers have been the provider’s Leveraged Coffee and Leveraged Cotton products.           
Open-ended actively managed funds have comparatively lagged their index-tracking peers over the past year. The strongest-performing open-ended fund over the past year, the t1ps Smaller Companies Gold fund, had grown to £1,681, or less than half of the ETF Securities Leveraged Silver ETC.
There is no doubt that levered strategies offer investors a way of making strong returns in the short term, particularly given the strong growth in the commodities market. But the strategies are high risk, which can be demonstrated by their short-strategy counterparts.
As the ETFS Leveraged Silver product was the strongest-performing fund, so its inverse twin – the ETFS Short Silver ETC – was the biggest loser, turning a £1,000 investment into just £300 over one year. Comparatively, the worst actively managed fund, the Huet Capital – European Residential Property Fund, would have lost £422 over the same period.
Of course, performance will always depend on the asset class and investment strategy, as much as returns will be defined by the investor’s risk appetite.
It is interesting to note, as shown in Table 2, that over a five-year period of investment, there is little to choose between actively managed open-ended funds and index-tracking ETPs, in judging best performance. The actively managed Smith & Williamson Global Gold & Resources fund would have turned a £1,000 investment into £2,308, just £231 less than the ETFS Gold Bullion ETC. Actively managed funds also demonstrate their value over the five-year period, with two China funds outperforming the second and third best-performing ETPs.
However, it is also worth noting that the poorest-performing active managers would have lost investors a lot of money. The aforementioned Huet Capital – European Residential Property Fund would have decimated a £1,000 investment over five years, turning it into just £240. The Legg Mason Japan Equity and Melchior Japan Opportunities would both have lost investors well over half their original investment, compared with the poorest-performing ETP, the iShares MSCI Japan ETF, which would have lost only £163.
Looking at the performance of other internationally listed ETPs, a more general picture emerges. According to data from Trustnet, the strongest-performing sector over the past year, based on the average performance, was the Global ETF Property – Europe, returning £1,253 from an initial £1,000 investment. The worst-performing sector was Global ETF Currency – Sterling, which would have lost £72 from an initial £1,000.
In the actively managed, open-ended sphere, the IMA UK Smaller Companies sector was the best performing, returning £1,220, while the IMA Japan sector was the worst performing, losing £101.
Over five years, these trends change somewhat. The Global ETF Equity – Greater China sector emerges as the strongest performer, with the average fund returning £2,320 from a £1,000 investment, while the Japan sector is the weakest performer, the average fund recording a loss of £203.
It would appear that investors in Chinese index-tracking funds would have recouped greater returns than those investing in open-ended funds. The IMA China/Greater China sector – the strongest performing over five years – would have seen £1,000 grow to £1,962, or £358 less than the average Chinese equity ETF. The worst-performing IMA sector over five years was Japanese Smaller Companies, making a loss of £362.
 
Age of the ETP
 
The debate in favour or against investment in ETPs is likely to rumble on for a long time yet. The products have yet to reach the same levels of popularity with UK investors as they have in the US, but this is widely attributed to the way that the financial advice market works in the UK.
With the implementation of the Retail Distribution Review (RDR) from 2013, changes in the way financial advisers are remunerated may see more of the commission-free products recommended and included in investors’ portfolios.
Providers say they have seen greater interest in the products, which already comply with the regulations.
David Bower adds, ‘Investors have started to consider how they might start to use ETFs, [and we expect] the level of interest to increase much further. We’ve seen a corresponding increase in the number of assets held on regulated platforms and saw that through 2010.’
The index-tracking products are likely to attract greater numbers of investors based on their competitive pricing structure. According to BlackRock, the total expense ratio (TER) for exchange-traded products with their primary listing in the UK is 52 basis points (0.52 per cent). This compares with an average TER of 1.61 per cent for open-ended funds in the IMA universe, according to Morningstar.
The industry continues to grow, too, with new products constantly being listed and new providers entering the market. Indeed, BlackRock estimates that the global ETF industry could grow by up to 30 per cent in 2011. Just last month, the UK ETP industry welcomed provider Amundi to the market, with other market entrants – particularly US giant Vanguard – thought likely to set up in the UK soon.
Yet, it may be some time before many investors embrace the products. The open-ended fund industry is well understood and dominated by star managers and big fund houses with big marketing budgets. There are many good actively managed funds, but picking through the many thousands to find the right product can take time.
One of the biggest factors may also be the inclusion of ETPs on all fund supermarkets, important distribution nodes for all investment products. ETPs are currently included on many wrap platforms, which allow investors to hold all their investments in one place.
The ETP industry is also beginning to offer greater diversity, with risk-rated funds of ETFs, now much more common, offering investors a lower-cost, risk-rated alternative to many multi-manager funds available in the IMA universe.
 
Keep track
 
The index-tracking investment industry that has become dominated by ETPs, is likely to continue to gain in popularity with greater numbers of investors.
The sheer breadth and diversity of ETPs will ensure that investors are able to gain access to an ever-expanding universe of markets and indices in an affordable way.
Indeed, it is part of a trend that is beginning to be noticed by the Investment Management Association, the asset manager trade body. It reported the highest net sales on record for tracker funds during the first quarter of 2011, with net retail sales of £824 million, a £694 million increase on 2010. The IMA said the 81 tracker funds now account for 6.8 per cent of the total funds under management in the UK, or £39.8 billion.