Exchange Traded Funds (ETFs) 12 th December 2012 Lydia Prieg nef - - PowerPoint PPT Presentation

Exchange Traded Funds (ETFs)

12th December 2012

Lydia Prieg

nef (the new economics foundation)

• The basic concept
• Physical ETFs
• Synthetic ETFs
• Actively Managed ETFs
• Commodities ETFs
• ETFs and systemic risk

Exchange Traded Funds (ETFs)

• First developed in Canada in 1990, before launching in

the USA and Europe in 1993 and 2000, respectively.

• Empirical studies concluding that mutual funds generally

struggle to out-perform the market.

• Originally ETFs just tracked equity markets, but in 2000

fixed income ETFs were introduced, followed by commodities ETFs in 2001.

• AUM have increased 349% in a period of five years, to

$1,839 bn in 2012.

• ETFs have yet to rival mutual funds, as the former are

currently only 6% of the size of the latter.

ETFs: The Basic Rationale

ETFs: What do they track?

Physical ETFs

• Fees vary enormously, even for ETFs that track large,

liquid indices.

• Some funds make very large tracking errors.
• How passive are they in illiquid markets?
• ETFs that track illiquid markets are only liquid as long as

market makers are prepared to provide liquidity.

• Securities lending means they don’t qualify as Unit

Investment Trusts in the US.

Physical ETFs

Synthetic ETFs

• Daily resetting means that the performance of the fund

will frequently differ from that of the advertised index it is tracking.

• Increased end of day volatility due to resetting.
• Many investors are unaware that their investment is

dependent on the financial health of investment banks.

• Collateral may have no relation to the market the ETF is

tracking.

• Securities lending may introduce additional risk.

Synthetic ETFs

• First launched in March 2008.
• Higher management fees.
• Tension between transparency and the market front-

running trades.

• Market makers won’t be able to arbitrage if they are

unaware of the content of the actively managed fund. This could result in significant trading departures from a fund’s true net asset value.

• Will these ETFs attract good fund managers?
• Industry still in its infancy.

Actively Managed ETFs

• They track a commodity’s futures price, not the price of

the physical commodity itself – this introduces roll yield.

• The rolling process is often highly expensive, and can

result in investors losing money, even when the price of the commodity itself has increased.

• Pre-rolling can occur.
• Dynamic rolling increases management costs.
• What percentage of the public who have bought such

ETFs understand ‘rolling’, and how it may impact on their investment?

Synthetic Commodities ETFs

• Many researchers have attempted to investigate the

effect of speculative investment on commodities prices empirically, but the findings, so far, have been mixed.

• However, there is a mechanism by which speculation via

futures can, in theory, impact on physical commodities prices.

• Whilst speculation undoubtedly can bring valuable

liquidity to a market and help smooth volatility, speculators now constitute the majority of participants in many commodities markets.

• Precautionary principle.

Synthetic Commodities ETFs

Composition of the Chicago Wheat Futures Market

• Avoid roll yield but incur expensive storage costs

(especially for base metals).

• Do they interfere with the underlying market?

– The market is incentivising investors to store physical commodities, as prices reflect the fact that these resources are more needed in the future than in the present. – But what happens if investors are still buying units in physically backed ETFs when there is a near-term shortage in the market? – Could metals grow to be seen as a safe-haven amidst a ‘flight to quality’, or used as a hedge against inflation?

Physical Commodities ETFs

• Regulators have already begun to issue warnings that

investment banks may not be able to cope if investors pull out en-masse from an ETF.

• ETFs also magnify the interconnectedness of investment

banks with the rest of the financial system.

• While investment in ETFs remains a small percentage
• f, for example, investment in traditional mutual funds, it

is unlikely that the industry poses a large risk to the financial system.

• If ETFs continue to grow at the rate seen in recent years,

this may soon no longer be the case.

ETFs: Systemic Risk?

Summary

• ETFs are no longer the simple, transparent products

they once were.

• Many should no longer be marketed to the general

public.

• Some are unlikely to make money for anyone other than

their providers.

• Doubts about how passive they really are.
• Unlikely to currently be a source of systemic risk, but, if

they continue to grow and the same rate they have done in recent years, they should be watched.

This presentation has been produced with the financial assistance of Aviva Investors and the European Union. The contents of this presentation are the sole responsibility of nef (the new economics foundation) and can under no circumstances be regarded as reflecting the position of Aviva Investors or the European Union.