ETFs: With Explosive Growth Comes Hidden Risks

This article was originally published in Arab Times

 

The global market for exchange-traded funds, or ETFs, has doubled in size in just four years to nearly US$1.5 trillion in assets today.  BlackRock, State Street Global Advisors and Vanguard lead the market with a combined share of roughly 84% of ETF assets.  Equity products dominate the scene and geographically the US and Europe account for the lion’s share of the market. Amidst this exponential growth and following an earlier article in the Financial Times (FTfm supplement) Dave Larrabee, Director of member and corporate products at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait, evaluate whether investors fully appreciate some of the risks associated with ETFs and their impact on the GCC region.

 

How can ETF’s develop local markets?

The development of ETF products can attract institutional investors, especially foreign investors, and can thus help deepen the local market. It will also enable the floatation of specialized products aimed at wealth preservation and volatility management.

 

Why are ETF’s not popular in the GCC?

In general, ETF’s have thrived in deep and liquid markets. Consequently, the poor and decreasing liquidity of GCC markets has had an impact on the evolution of ETFs in the region. Also, the development of ETF markets require active institutional investor participation which is generally lacking in the GCC since their markets are predominantly retail driven.

 

What is behind the popularity of ETFs?

The popularity of ETFs with investors is attributable to the ease with which they can be bought and sold, their tax efficiency, low cost and their ability to provide broad diversification within an asset class, sector or geographic region.  ETFs trade throughout the day like stocks and like stocks can be shorted and purchased on margin.  ETFs are generally more tax efficient than mutual funds, though they still pay out dividends and gains arising from changes in the underlying indices they track. While mutual fund redemption requests can force fund managers to sell stocks and incur capital gains that are then passed along to shareholders, with ETFs, the underlying portfolio remains the same when an investor buys or sells shares. 

 
The versatility of ETFs has made them especially popular with financial advisors and individual investors.  ETF sponsors have capitalized on the demand for ETF products by aggressively expanding their offerings.  The development of more exotic types of ETFs, including leveraged, inverse and synthetic ETFs, have brought greater complexity to the market, and investors may not fully understand the risks embedded in these products.

 

What are the principal risks associated with ETFs?

The degree of risk ETF investors face varies depending on factors like the type of ETF, the fund strategy, the nature of the underlying assets and the fund sponsor.  Risks can include tracking error risk, counterparty risk, collateral risk and currency risk.  Most of the focus of late has been on risks associated with some of the more exotic versions of ETFs, including leveraged, inverse and synthetic funds.  Most leveraged and inverse ETFs are designed to deliver a multiple of the daily underlying index return using swaps, futures and other derivatives.  Over longer periods of time, volatility erodes the returns that short-term oriented funds like these are designed to deliver, often resulting in large performance differences between the ETF and its underlying index. 

Synthetic ETFs, which are popular in both Europe in Asia, attempt to replicate an index using asset swaps with counterparties.  The sponsor then often backs the synthetic ETF with often lower quality, less liquid collateral that does not match the underlying assets.  An ETF forced to liquidate assets could easily find that its collateral is suddenly worth much less.

 

Are ETFs responsible for increased market volatility?

While synthetic, leveraged and inverse ETFs account for a relatively small portion of industry assets, they may have an oversized impact when it comes to contributing to market volatility. The G20’s Financial Stability Board, The International Monetary Fund, and the Bank of International Settlements have each cited synthetic ETFs as potential threats to global financial stability. Critics of leveraged and inverse ETFs say they can artificially magnify sell-offs and also create short squeezes, and this systemic risk was noted in a 2010 report by the Kauffman Foundation. Whether recent market volatility can be definitively attributed to the growth of ETFs, or the use of specific ETF products, is still being studied and debated.

 

Are there any important regulatory concerns or issues facing ETFs?

Increased market volatility, including the “Flash Crash” of May 2010, when the Dow Jones Industrial Average fell nearly 1,000 points in just minutes, put the regulatory spotlight on ETFs, along with high frequency trading.  And the 2011 UBS rogue trading scandal involving allegedly fictitious ETF trading has heightened the scrutiny of lawmakers.  The absence of over the counter (OTC) trade reporting requirements in Europe, where 60% of ETF trades take place OTC, have raised transparency concerns.

The U.S. Securities and Exchange Commission is reportedly investigating leveraged ETFs and their impact on market volatility.  And the European Securities and Markets Authority has called for tighter regulations and recommended greater transparency and disclosure regarding the risks posed by ETFs. 

 

What Are the Key Takeaways for Investors?

ETFs offer investors diversification and tax efficiency at a comparatively low cost, and strong investor demand has driven dramatic industry growth.  In their more exotic forms, however, ETFs can bring unintended and excessive risk to portfolios.  Accordingly, it is critical that they be analysed carefully and used judiciously by investors.

The Mega Rupee Slide: Is the worst over?

The Indian Rupee (INR) is the worst performing currency in the world during 2011 (Table-1). At Rs.52/USD it slid by a whopping 17% during 2011 and 6% in November alone. The following questions emerge out of this:

1.       Why did the rupee depreciate so fast?

2.       What is the further downside and how low can it go? &

3.       What should be the strategy?

Let me try and answer them one by one:

1.     Why did the Rupee depreciate so fast?

Technically rupee depreciates against the dollar when people sell rupee and buy dollars. There are four reasons cited for this:

a.       Economy (both global and domestic) and Trade

b.      Stock Market

c.       RBI &

d.      Corporate Hedge

Economy & Trade:

Indian economy, after growing briskly during the last few years, is expected to slow down during this year and next. From a growth rate of close to 9%, the forecast now is about 7 to 7.5%. This is on the back of global slowdown and other associated problems.

Indian economy’s deficit is spiraling out of control. Both the fiscal deficit and current account deficit are headed for further deterioration during this year and next. While the fiscal deficit (not counting the states) is headed towards 4.5%, the current account deficit is projected at $44 billion or 2.6% of GDP. This is in sharp contrast to China which is expected to post a Current Account surplus of $305 billion or 5.2% of its GDP.  The current account deficit is triggered primarily by trade deficit (Export-Import). Not only our imports exceed exports, but even within the imports the dominance is by oil and gold imports, something very difficult to control.

While this is the domestic story, the global events are not too encouraging either. Both the US and Europe are struggling with one crisis after another with no solution in sight. The US lawmakers are finding it difficult to arrive at a consensus on deficit reduction. Any stalemate on this will make investors exit high yielding emerging market assets in favor of US Treasuries which means buying more dollars. This is technically the reason why USD is appreciating even though USA is in deep mess.

Stock Market:

The Indian stock market is down by 20% for the year on the back of poor global market sentiments and sagging earnings. However, the key to stock market performance has been the liquidity which to a great extent depends on Foreign Institutional Investors (FII’s). For FII’s, their overall return is a function of both stock market performance and currency performance. In other words, a great scenario for them would be a good stock market and appreciating currency. On the flip side, a lousy combination would be to have a negative stock market and depreciating currency. For eg. If stock market slides by say 25% and currency depreciates by say 10%, then the total loss is 35% in dollar terms which is a double whammy.

FII’s have been significantly ramping up their inflows in the Indian stock market during the last several years (Table 2).  However, trouble in US and more recently in Europe has increased their risk aversion and this resulted in sharp drop in foreign inflows in Indian stock market during 2011. This reduces demand for rupee leading to its depreciation.

RBI:

Reserve Bank of India is tasked with ensuring the financial stability of the economy and hence is the sole inventor of the monetary policy. In the past, when currency encountered volatility or undue fluctuations, RBI used its foreign exchange reserves to intervene in the market (through purchase or sale of dollars) and thereby reduce the volatility of the currency. However, this time around, they raised their hand and declared openly their intention not to interfere in preventing the rupee slide.

In a way such a clear cut communication is good as at least market players can guesstimate the likely outcome, but such a declaration is also an open invitation for speculators to short INR. More importantly let us understand as to why RBI has adopted such a “no intervention” policy. It is a strategic choice. If RBI thinks that the problem is temporary and hence any small intervention can bring the equilibrium back, then it is worth taking the risk. However my assessment as to what RBI thinks on this subject is that it expects the global economy to further deteriorate and hence it may not want to waste the precious foreign exchange reserves ahead of time only to be a lame watcher towards the later part of the episode.  For 2010/11, the foreign exchange reserves totaled $282 billion and represented roughly 7 months of imports. For China, it amounted to $2,884 billion and represented 21 months of import cover, a far comfortable situation to be in. Hence, we can clearly understand the predicament of RBI to intervene.

Corporate Hedge:

Many CFO’s turned quite easy and relaxed due to continued rupee strength during the last few years. They expected this to continue forever and hence did not bother to hedge their currency risk exposures, especially if you are an importer. However, all of them were caught off guard by the turn of events due to which they ran for cover to hedge their exposure which led to intense buying of dollars leading to its appreciation. On the other hand, exporters are still watching and waiting for even more fall so that they can reap a windfall.

2.     What is the further downside and how low can it go?

The rupee has clearly caught everyone by surprise by its fast slide. When you look at comparative numbers for other emerging markets and developed markets (Table 1), this slide is indeed very sharp and unexpected. Research agencies and investment banks now say that if RBI does not step in, then Rupee can further slide to Rs. 55 or even Rs. 57 by the end of the year.

However, to get a long-term trend,  let us revisit the four points explained above and see how they will evolve as we move forward:

	Analysis	Assessment
Economy	It is very clear that global growth will struggle for the next few years. However, India is not an export-dependent economy like China. It is a consumption-led economy. Hence, even in this gloomy global scenario, we can expect Indian economic engine to roar at 7% minimum. Hence, we are on strong turf on this.	POSITIVE
	The deficit is a long-term problem especially the fiscal deficit. No matter which government is in place, populist policies will ensure that the deficit does not come down. However, if they do not go up, then that itself will be good news. On the other hand, the current account deficit may come down in the future primarily because of rupee depreciation. Importers will either reduce their imports or hedge while exporters will ramp up exports to take the best advantage of a weak rupee. This may turn the trade deficit to more favorable terms which will in turn reign in the CA deficit.	NEUTRAL
Stock Market	FII investments will not come back unless some calmness returns to US and Europe financial markets. And without their strong inflows, there is no way stock markets are going to get their insulin. However, we should also not forget the fact that there are very few investing opportunities around in the world today. Hence, at the instance of first signs of stability in the global economies, liquidity will start flowing once again to emerging stock markets especially India. This may not happen in 2012 but will eventually happen in later years.	NEUTRAL
RBI	RBI, with just 7 months of import cover in terms of foreign reserves, does not have the fire power to prevent a rupee slide. Also, RBI actions are always short-term and cannot produce long-term directional change to the fortunes of rupee. Also, the RBI actions of late to control inflation have met with huge failure raising its credibility and ability to pursue and implement sound policies.	NEGATIVE
Corporate Hedge	The current slide can be partly attributed to the rush to cover the exposure. With the erratic behavior of the currency, finance managers and CFO’s will be wiser to hedge future exposure which may prevent volatility. Also, the depreciation of rupee will help increase exports which will bring in the much needed USD.	POSITIVE

Hence, as we can see, all factors are either neutral or positive with only RBI being on the negative assessment. This means that there isn’t more danger on the downside to the rupee.

3.     What should be the strategy?

Currency and interest rates are the hardest thing to estimate in financial markets. Hence, the best thing would be to hedge and not try and anticipate currency movements. Having said that, the following could be done:

If you are a domestic investor, you should focus on export oriented sectors like IT for investments. They will have a great year ahead.

If you are a non-resident Indian, this probably is the best time to remit money to India. If you have dollar investments, it will be wise to exit the position and remit the money back to India.

If you are a corporate in India with significant foreign exchange exposure (either as importer or exporter), it is time to have some sound hedge in place as currency volatility is only expected to increase than decrease.

Table-1: Currency Performance

Currency Against USD	Nov-11	YTD	2010	2009	2008	2007	2006
BRAZILIAN REAL	3.5%	9.3%	-4.8%	-25.2%	31%	-16.6%	-9%
RUSSIAN ROUBLE	1.2%	2.1%	0.7%	-0.7%	24%	-6.8%	-8%
EURO	-1.5%	0.4%	-6.5%	3.2%	-5%	10.9%	12%
UK £	-2.0%	-0.2%	-3.0%	12.3%	-28%	1.7%	14%
JAPANESE YEN	-1.7%	-5.1%	-12.9%	2.7%	-19%	-6.2%	1%
THAI BAHT	0.8%	3.3%	-9.6%	-4.1%	3%	-6.8%	-12%
PAKISTAN RUPEE	1.4%	1.9%	1.6%	6.6%	28%	1.2%	2%
INDIAN RUPEE	5.9%	16.6%	-3.9%	-4.5%	24%	-10.9%	-2%
SINGAPORE $	2.1%	1.8%	-8.8%	-2.6%	0.09%	-6.2%	-8%
CHINESE RENMINBI	0.1%	-3.6%	-3.3%	-0.1%	-6%	-7.0%	-3%

Source: Reuters

Note: Positive sign indicates depreciation and vice-versa

Table-2: FII inflows

Rs cr
Financial Year	Equity	Debt	Total
1992-93	-	-	13.4
1993-94	-	-	5126.5
1994-95	-	-	4796.3
1995-96	-	-	6942
1996-97	-	-	8574.5
1997-98	5267	691.1	5957.2
1998-99	-717.2	-867	-1584
1999-00	9669.5	452.6	10122.1
2000-01	10206.7	-273.3	9933.4
2001-02	8072.2	690.4	8762.6
2002-03	2527.2	162.1	2689.3
2003-04	39959.7	5805	45764.7
2004-05	44122.7	1758.6	45881.3
2005-06	48800.5	-7333.8	41466.7
2006-07	25235.7	5604.7	30840.4
2007-08	53403.8	12775.3	66179.1
2008-09	-47706.2	1895.2	-45811
2009-10	110220.6	32437.7	142658.3
2010-11	110120.8	36317.3	146438.1
2011-12 (till Sep30, 2011)	2209.3	6478.8	8688.1
Source: SEBI

PS: The author thanks Humoud Al-Sabah and Deivanai for data assistance