Awareness Is Key for ETF and ETP Investors

This article was originally published in Arab Times

The asset management industry in the GCC region has shown growth amidst turbulence. The region manages nearly $30 billion in over 325 funds. After Saudi Arabia, Kuwait is the largest market in terms of assets managed under mutual funds. However, the concentration of funds is heavily skewed in favor of active funds with very little presence of index funds or Exchange-traded funds (ETF’s). The absence of institutional investors is a key limitation for local markets. It is estimated that the institutional presence is less than 10% compared to over 25% for emerging markets and over 75% for developed market. Authorities are keen to deepen the stock market through institutional presence especially foreign investors. However, foreign investors typically commence their exposure through passive vehicles like ETF’s. Hence development of ETF’s could be a good thing to attract such investors to the region. Also, development of ETF’s can aid in structuring more robust products than plain vanilla country funds.  Globally, assets of exchange-traded funds (ETFs) and exchange-traded products (ETPs) surpassed $1 trillion near the end of 2009, up some 45 percent year over year.  This article first appeared in FTfm on May 3 2010.

Samuel Lum, CFA, and Mandagolathur Raghu, CFA reviews the dynamics of this growth and its implications for investors.

 

Q. What are some recent developments in the ETF/ETP area?

After a drop in 2008, asset growth for ETFs and ETPs has resumed, surpassing the $1 trillion milestone in 2009. There are now more than 2,600 ETFs/ETPs, with some 4,800 listings on more than 40 exchanges from about 140 providers, and hundreds are currently in the planning stage. Moreover, ETFs and ETPs accounted for around 30 percent of NYSE trading in 2009. 

Providers continue to launch products with new asset class and market exposures, replication approaches, management styles, and legal structures. Other new products include faith-based ETFs, actively managed ETFs, fundamental and other non-cap-weighted index ETFs/ETPs, and the first hedge fund ETF.

 

Q. What is the key difference between ETFs and ETPs?

Although ETFs and ETPs are similar in the way they trade and settle, ETFs typically use an open-end investment company structure, whereas ETPs take the form of notes, commodity pools, partnerships, trusts, or other structures. ETFs have been around much longer than ETPs and their assets and number of listings is much larger.

 

Q. What is the industry backdrop to the recent growth?

Investment banking revenue dwindled after the collapse of Lehman and the bailout of AIG heightened investors’ concerns about counterparty risks embedded in structured products. A cool market for credit and security issuances further reduced revenue. Issuance fees and market-making revenues from ETFs/ETPs represent a growing alternative revenue source.

Index providers also find that ETF/ETP issues complement their core business well. Nonetheless, traditional funds still have 12 times more assets than do ETFs.

  

Q. Do ETFs/ETPs contain counterparty risk? 

ETPs that use direct replication often lend the underlying securities for additional income. Although the counterparty risk exposure to borrowers could be addressed through diversification and tight collateral monitoring, risk management practices have neither explicit requirements nor transparency. 

ETPs that use synthetic replication are usually required to diversify the exposure to a number of counterparties (e.g., European-domiciled ETPs under the UCIT regime). Some ETPs are further collateralized with U.S. T-bills to eliminate counterparty risk. 

Q. How do fees and expenses stack up?

 

Although ETF/ETP fees and expenses are often lower than their traditional index fund counterparts, ETP providers are sometimes able to generate additional income by lending securities and by charging customers the normal bid–ask spread while actually executing at much tighter spreads by crossing or exploiting efficiencies in their trade execution platforms. For example, some U.S. and U.K. brokers have been offering zero-commission trading. In fact, some ETF/ETP issuers are giving rebates, or retrocessions, to private banks and institutional investors. 

 

Q. What are tax considerations for European, Asian, and other non-U.S. investors?

For U.S. investors, tax efficiency is often cited as an advantage of ETFs/ETPs because the creation and redemption process for shares is treated favourably from a tax perspective. For European, Asian, and other non-U.S. investors, however, distributions from certain U.S.-domiciled ETFs could be subject to a withholding tax of up to 30 percent, depending on the tax treaty and specific investor circumstances.

European, Asian, and other non-U.S. investors in European- or Asian-domiciled ETFs may not be subject to a withholding tax. Other considerations (e.g., liquidity, counterparty risk) could counterbalance the tax considerations.

 

Q. Are there tracking-error issues?

As previously documented in this column, some inverse and leveraged ETFs/ETPs, especially those that track a geared multiple or inverse of a particular index, have failed to track their benchmarks, sometimes by wide margins. As an alternative, many advisers try to help clients borrow and short ETFs/ETPs instead of using leveraged ETFs/ETPs. 

Investors will also need to assess the risk that the provider may fail to meet local regulatory requirements. At least one index ETF has started trading at a discount to net asset value because of regulatory breaches.

 

Q. Are ETPs and ETFs a viable tool for fund managers?

ETFs and ETPs can be efficient, low-cost tools for implementing a sound investment strategy. Fund managers and portfolio managers, however, must be aware of the unique counterparty risks, tracking errors, and tax considerations that vary from product to product and that might otherwise be overlooked in this fast-growing industry.