Talking Point

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Should ETFs come under more scrutiny?

Product innovation has resulted in structural complexities
By Imran Ahmed through a regulated exchange, say the Chicago Mercantile Exchange (CME). On the other hand, if any transactions are over the counter trades then the risks for an ETF increase dramatically. Counterparty risk is particularly relevant for ETFs structured as exchange traded notes. Exchange traded notes are a type of debt security, the returns from which accrue to the investor. In an environment where the failure of financial institutions hardly merits a newspapers front page, counterparty risk is a genuine concern for investors in particular ETFs. Retail investors are likely to be uninformed of the hazards counterparty risks devolves onto ETF investments. The pricing of ETFs follows the same simple principles as their mutual fund counterparts: an aggregation of the funds net asset value (NAV). Nevertheless, calculating an ETFs NAV became progressively more complicated as ETFs move away from earlier straightforward structures to synthetics and investments in exotic asset classes. Van Ecks Market Vectors Egypt Index ETF (EGPT), designed to track the performance of one of the Egyptian stocks, is one example. Earlier in 2011, political unrest in Egypt closed the Cairo Stock Exchange (CSE) for approximately seven weeks. While EGPTs managers stopped the creation of new ETF units within a few days of the closure of the Cairo Stock Exchange, it continued to honour redemptions. Significantly, Van Eck confirmed the company determined fair value for the portfolio while Egypts market was closed.2 Media reports quote Van Eck officials suggesting the company look[ed] at factors such as the movement of the Egyptian pound, other markets and correlations as well as news and material events. Also, some of Market Vectors Egypt Index ETFs holdings are listed in London and Canada.3 Granted, trading in a few Egyptian global depositary receipts provides some clues for valuation, but surely not enough to value an entire

overnments and regulators have a palpable tendency to ignore matters until either the subject becomes too important to ignore or a crisis occurs. Exchange traded funds1 are no exception to this general rule. In fact, ETFs have the dubious distinction of having ticked boxes next to both conditions: the global ETF industry has assets under management of over US$1 trillion and the most recent two billion US dollar scandal at the UBS ETF desk has shaken the financial community. ETFs are no longer exotic products. ETFs are an intrinsic part of the global capital markets. Therefore, any dislocations in the ETF sector will likely have contagion effects on other areas of the financial sector. Already, rightly or wrongly, many analysts tend to parcel

Most professional investors are aware that ETFs come in several forms, particularly physical versus synthetic ETFs. Synthetic ETFs tend to be popular for funds tracking commodities or other non-equity assets. Unlike physical ETFs which invest directly in the asset they intend to track, synthetic ETFs attempt to track an underlying assets return through transacting in derivative products such as swaps, futures or options. As a result, the returns generated by synthetic ETFs often diverge materially from the return of their intended asset or benchmark. Retail investors are frequently unaware of the performance risk embedded in synthetic ETFs. An investor purchasing the United States Oil Fund ETF (USO) will seldom consider that

In an environment where the failure of financial institutions hardly merits a newspapers front page, counterparty risk is a genuine concern for investors in particular ETFs

part of the blame for increased stock price volatility on the popularity of ETFs. Clearly, in todays delicate financial environment where even the slightest ripple can turn into a tidal wave, regulating ETFs is a key priority for maintaining financial stability. ETFs started as a simple product which tracked uncomplicated investment benchmarks. However, due to continuous product innovation during the last decade, ETFs moved into uncharted territory. Many of these advancements have precipitated and embedded unforeseen risks within ETFs. Some of the areas warrant a closer look by regulators. They include the issues of counterparty and performance risk within synthetic ETFs, pricing of ETFs with illiquid underlying securities and, finally, leveraged or supercharged ETFs. 14 ETFI ASIA 2011 Q4

USOs price performance may deviate significantly from that of oil. Likewise, investors purchasing the Coffee ETF or JO may also believe they have bought a security which will closely track the price of coffee. For obvious reasons, most unsophisticated investors closely associate an ETFs return with its underlying asset or benchmark and do not adequately investigate an ETFs portfolio holdings or tracking error.

Counterparty risk
For synthetic ETFs, another area of concern is counterparty risk. Counterparty risk arises primarily due to the derivative contracts entered into by an ETF. Undoubtedly, such risks are somewhat mitigated if the derivative transactions, e.g. futures, are executed

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portfolio of Egyptian stocks in the absence of a functioning domestic exchange? Following the cessation of EGPT to create new units during the seven weeks the CSE remained closed, EGPT traded similar to a closed end mutual fund. At times, EGPTs premium over NAV jumped to over 20%. Of course, the premium was dependent on the calculation of an imperfect NAV, given that only four out of 28 of EGPTs holdings traded during this period.4 Trading the EGPT ETF was a dangerous proposition for investors, retail or professional, as the impact of political unrest on future stock prices could not have been accurately predicted. Certainly, valuation of EGPTs ETF strayed from normal principles applied to calculating an ETFs NAV.

daily performance of the S&P 500 Index.5 As the name implies, leveraged ETFs contain inbuilt mechanisms to provide leverage to investors. In practical terms, this suggests investors take an increased amount of risk when investing in a leveraged (as opposed to a nonleveraged) ETF. As a result, potential investment losses are magnified by leveraged ETFs. It is unclear whether an average investor is informed about the higher risk profile of leveraged ETFs during the purchasing process. Managing investment risk is not the role of a securities regulator; nor is defining the ability of investors to

ETFs have rapidly evolved in various directions. Product innovation has resulted in structural complexities. The risks related with these intricacies are not always well known or understood by many ETF investors. Given the growth of the ETF industry, closer supervision appears virtually inevitable. As Britains Financial Services Authority pointed out in its most recent Retail Conduct Risk Outlook report, risks associated with ETF industry have surfaced on the radar screen of regulators. Since the complexity of ETFs has changed quite quickly and materially it is not clear that retail investors fully

Leveraged ETFs
Leveraged ETFs, as measured by assets under management, are not enormously popular with investors. Nonetheless, these supercharged ETFs are here to stay. Essentially, a leveraged ETF uses financial instruments to amplify the (positive or negative) returns of a particular index. For example, the ProShares Ultra Standard and Poors 500 (SSO) seeks [to deliver] daily investment results, before fees and expenses, which correspond to twice the
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Managing investment risk is not the role of a securities regulator; nor is defining the ability of investors to purchase different classes of securities

purchase different classes of securities. However, a regulator plays a pivotal role in improving product transparency and information to potential investors. Since their humble beginnings in the 1990s,

understand their underlying risks. In addition, complex ETFs are relatively new products for many retail investors and their advisers. This lack of familiarity could exacerbate the products risks.6

For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs). Egypt ETFs Cash Position, NAV Premium Shrink. March 30th, 2011. John Spence. ETF Trends, retrieved on November 16, 2011. http://www.etftrends.com/2011/03/egypt-etf%E2%80%99s-cash-position-nav-premium-shrink/ Egypt ETFs Cash Position, NAV Premium Shrink. March 30th, 2011. John Spence. ETF Trends, retrieved on November 16, 2011. http://www.etftrends.com/2011/03/egypt-etf%E2%80%99s-cash-position-nav-premium-shrink/ The quotation is not a verbatim script of a statement by Van Eck but a summary of an interview by a Van Eck officer. Egypt ETF Trades At Premium Over NAV. March 1st, 2011. Tom Lydon. ETF Trends, retrieved on November 16, 2011. http://www.etftrends.com/2011/03/egypt-etf-trades-premium-over-nav/ From Yahoo Finance retrieved November 16, 2011. http://sg.finance.yahoo.com/q?s=sso&ql=1 Retail Conduct Risk Outlook. Financial Services Authority. February 2011. Retrieved on November 16, 2011. http://www.fsa.gov.uk/pubs/other/rcro.pdf

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