October 2011


HandcuffsThe UBS rogue trader scandal has reignited the controversy over exchange traded funds at a time when the French banking system is worryingly exposed to Greek debt. But investment professionals say most buyers are institutional investors who know the risks, writes George Mitton.
The market for exchange traded funds (ETFs) continues to grow in Europe. Transparent, readily accessible and increasingly popular, these instruments are generally cheaper to operate than actively managed funds because they passively track an index. But recent events have put the spotlight on ETFs. Kweku Adoboli, the UBS trader who allegedly lost his employer more than €1.6 billion through rogue trading, dealt in ETFs. Critics say this calls for a fresh examination of these instruments. For French firms, the scandal is reminiscent of when Jerome Kerviel lost €4.9 billion for Société Générale in 2008 using delta-one strategies that are similar to ETFs. Can asset managers convince the public that these funds are safe? The full account of the UBS loss is still emerging, but already the alleged fraud has been collated with existing concerns about synthetic ETFs. Because they rely on derivatives, these are exposed to the risk that the counterparty will default, as Lehman Brothers did in 2008. For French firms, the risk may seem more daunting because of the problems facing the country’s banking system. France holds more Greek loans than any other European country: $57 billion (€42.4 billion), according to the Bank for International Settlements. However, the view from ETF providers in France is defensive. Gilles Guerin is head of Theam, the ETFs and structured products business owned by BNP Paribas. He says the firm’s business has not been affected by the current anxiety about counterparty exposure and asserts that the firm’s synthetic ETFs carry little risk because Theam deals almost exclusively with BNP Paribas. “I was in the US over the summer and there was some real concern for European banks. Not specifically BNP Paribas, but all banks,” says Guerin. “Has it impacted on our business at this point in time? Absolutely not. “The funds managed by Theam have no exposure to Greece, except a few percents in our fixed income indexed funds which replicate the EMU government bond index,” he adds. “I don’t see it as a risk for Theam.” Since interviewing Guerin, two French banks, Credit Agricole and Société Générale have had their credit ratings downgraded by ratings agency Moody’s, and BNP Paribas has had its Aa2 long-term rating held under review. “In the next few weeks and months there will be a lot of uncertainty,” he says. “Will it have a major impact in 2012? I don’t think so, at least not for our business.” Guerin argues that having a strong bank to deal with is an advantage, as it may mean his business benefits if other ETF providers with weaker partners get into difficulties. “If we are to have problems, it will be so far down the road, after all the others, that it may actually be an opportunity rather than anything else,” he claims. But others take a different approach and believe it is safer to deal with a number of different banking partners so as not to lose everything if the one partner goes bankrupt. “One of the concerns which is quite often raised is when one provider is working with one investment bank,” says Pascal Voisin, chief executive officer at Natixis Asset Management. “You have a huge counterparty risk. Even for the synthetic part with swaps that we are using for Ossiam [a Natixis subsidiary], we have several providers that we are using and this is done as a competitive process.” This view, that it is safer to deal with multiple counterparties, is at odds with the strategy pursued by Theam and others that are owned by a bank and use their parent for the majority of derivatives transactions. However, it is not only on the synthetic side that there are risks. “The players with the cash ETFs are often failing to tell everything about what they do,” says one executive. “Especially when you look at repo.” Repo, or repurchase, is the practice of reusing securities as collateral to get new loans. Though this is a widespread, if controversial, banking practice, the fact that some providers may be employing repo on ETF assets has concerned some investors. Warnings and risks
The Bank of England warned in its Financial Stability Report published in June, that ETFs are not suitable for all investors. Less sophisticated retail investors could buy a synthetic ETF without knowing if the product is exposed to counterparty risk, for instance. However, many in the industry argue that the problem of potential mis-selling to retail investors has been overstated. Simon Klein is the head of ETFs at Lyxor, which jostles with BlackRock-owned iShares as the top ETF provider in Europe with about 25% market share each. He says four-fifths of buyers are institutional investors. These are professionals who “have been educated and informed about our structure”, he says. Klein argues that institutional investors can be expected to know about counterparty risk and, if they choose to buy a synthetic ETF, it is because they like the transparency and liquidity of the product and consider the risk to be worth taking. Although retail investor interest in ETFs is growing, Klein does not expect a dramatic surge in demand from this segment. “It is likely that institutional investors will continue to be the main drivers of growth in ETF assets and trading volumes in the near term,” says Klein. “Large investors across Europe are constantly looking to benefit from efficient market exposure and this typically leads them to consider ETFs.” His opinion is shared by Guerin, who says he is not planning a big push to sell to retail buyers. “To be honest, we want ours to be a tool for institutional investors,” says Guerin. “If, marginally, some retail investors are buying them, great. But we’re not actively working on that.” Institutional investors will certainly have plenty of products to choose from. There were 1,185 ETFs available in Europe with combined assets under management of $321 billion at the end of June, according to BlackRock. As asset managers struggle to cut their costs and improve their profit margins, there could well be more of these vehicles hitting the market soon. According to Yves Perrier, chief executive officer at Amundi, the financial services industry is set to face sustained pressure on cost, which suggests there will be fertile soil for cheap, efficient ETFs. “To get yield to investors, the whole banking industry needs to dramatically reduce its cost,” he says. “There is no reason for the banking industry to have growth in the long term higher than global GDP, but that was the case during the ten years from 1997 to 2007. I don’t think we will return to those times because they were quite simply not normal.” ©2011 funds europe

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