Abandoned briefcase at the airport

How dangerous are synthetic ETFs in Canada? No one knows

Concern about ETFs started with leveraged ETFs during the 2008-2009 downturn. They disappointed investors who didn’t understand the impact of volatility disclosed in prospectuses. Then the May 6, 2010 flash crash sent the Dow Jones Industrial Average plummeting 9% before it immediately recovered. ETFs were suspected but have been exonerated. The recent £1.3-billion trading loss by a director of UBS’s ETF and Delta 1 trading desk has rekindled the debate.

How real is the problem?

Much like an abandoned briefcase at the airport, nobody knows for sure. No ETF has caused a meltdown of the financial system.

The problem is international banks, acting as counterparties for swap-based ETFs, have questionable balance sheets and may be too close to the sponsors. The result has been collateral with uncertain pedigree. Collateral adequacy is also a question for the widespread practice of securities lending.

Interest in ETFs has grown exponentially. Transparency, flexibility, tax efficiency and low cost have made them popular with institutional and retail investors alike. ETF construction is varied, some holding securities and others using derivatives. Within each of these groups there are further variations.

Things that cost too much or too little need to be watched more closely. The ETF Screener on the TMX Money website divides all ETFs into two types:

• Passive strategies:

  capitalization-weighted full replication—hold securities in the exact weight of their conventional target index.

• Embedded strategies (everything else):

  includes leveraged and inverse, active, style-based, equal weight, and others that use derivatives.

All of these involve additional costs from rebalancing, forward or swap contracts, and some are subject to counterparty risk, that demand additional scrutiny.

The industry’s wake-up call was suggested by the Financial Services Authority—the U.K.’s version of the Securities and Exchange Commission—to ban or restrict retail purchases of swap-based ETFs.

This is like an outright ban on smoking, lottery tickets, unpasteurized cheeses or spicy foods. All come with risks, but for a regulator to suggest it knows better than consumers is alarming. So alarming, in fact, that BlackRock has called for voluntary industry changes in five areas: product labelling; holdings and exposure to derivatives disclosure; diversification of counterparties and collateral quality; uniform cost disclosure; and universal trading standards and reporting.

BlackRock may have much to lose if restrictions are imposed. But its competitors—several more aggressive in their derivatives use—have more at stake. Transparency remains key.

How much risk in Canada?

The chart “Global synthetic ETFs” shows ETF asset exposure to synthetics as at December 2010. Under 10% is yellow, 11% to 30% is grey, over 30% is blue. Also shown are percentages of synthetic ETFs to all ETFs. Canada has only 6% of ETF assets in synthetics. Twenty-nine percent of all ETFs have synthetic structures, according to Pat Chiefalo at the National Bank, who provided data.

European clustering is evident, particularly in the largest markets, Germany and France. Given the European Union’s challenges, exposure to undisclosed bank counterparty risk is concerning. Swap transactions are the most potentially toxic structure because of counterparty risk and lack of mandatory collateral disclosure. In Canada, there are three swap structures: Horizon S&P/TSX 60 Index ETF (HXT), its USD clone (HXT.U), and the Horizon S&P 500 Index Canadian dollar hedged (HXC). All are 100% collateralized with cash.

Could Canada get worse?

When an ETF’s sponsor and counterparty are the same, less liquid collateral may slip into the mix and adequacy may not be a priority when dealing with a colleague at the water cooler. If a bank decided to act as counterparty for its own swap-based ETF, there would be potential for abuse.

The remedies suggested by BlackRock and others calling for disclosure of collateral and counterparty relationships with standards of diversification of collateralized assets are sound.

Disclosure has made ETFs popular; that should be extended to collateral with limits to self-dealing. Derivatives can benefit investors, so it would be a shame if regulators denied access. Regardless, caveat emptor.

Mark Yamada is President & CEO of PUR Investing Inc., a software development firm specializing in disruptive strategies for investors, their advisors and pension plans. PUR is a registered portfolio manager. www.purinvesting.com