March 2012

ETF SERVICING: The truth about physical ETFs

To_do_listMany complications are involved with servicing physical ETFs that do not apply to synthetic ones. George Mitton reports.

The administration of a typical physical exchange-traded fund (ETF) goes like this: every night the fund administrator creates a portfolio composition file which lists what the contents of the fund will be the next morning, accounting for any dividends or corporate actions that will affect the holdings.

This file tells market makers, which are responsible for bringing ETF units to stock exchanges, how much they must pay to create units, or how much they will get for redeeming them.

But the file is more than just a pricing tool. If a market maker wants to do in specie dealing, in which ETF units are created in exchange for securities instead of cash, the portfolio composition file represents a shopping list; the exact set of securities a market maker must supply to get ETF units in return.

Now take a synthetic ETF, which relies on swap transactions with a bank.

Here, in specie dealing is impossible. The portfolio composition file does not act as a shopping list and the fund value is derived from the index tracked by the ETF.

Although synthetic funds have been the target of much criticism in recent years – some say they are poorly understood by investors and not transparent enough about the counterparty risks they take – it is physical products which are, from an operational point of view, more complicated.

“The portfolio composition file on a synthetic fund is made up of what’s in the index,” says Rob Rushe, head of ETF servicing at State Street Global Services. “From that perspective it’s very straightforward to produce.”

Because it is easier to produce, many ETF providers make their own portfolio composition files based on what they are sent by their index provider, although some firms outsource this to a company, such as Markit ETF Services. For physical products, the fund administrator usually does the job.

‘Cumbersome process’
Ossiam, a French ETF provider part-owned by Natixis, operates both synthetic and physical products. For its synthetic ones, it makes the portfolio composition files itself using data from the index provider, but for its physical products, the process is outsourced to its custodian bank.

Fabien Dornier, chief investment officer at Ossiam, says the custodian bank has to be a large player to deal with the complexities, especially the “cumbersome process” of in specie dealing. However, he notes that synthetic ETFs have particularities of their own.

“Synthetic ETFs have derivatives to value, so you have to do some pricing,” he says. “This doesn’t exist in physical.”

There are further complications with physical ETFs, particularly with emerging market products. Take an ETF that tracks the South Korean stock exchange. If a market maker wants to create more units with in specie dealing, it must buy more Korean stocks, which means managing that country’s currency restrictions.

The share transactions cannot be made right away and will often settle two days later, but by this time the currencies may have moved, potentially leaving the market maker out of pocket. The solution is to use a currency hedge, which adds cost.

Another complication is that, because the portfolio composition file is so important to the market makers, the system is exposed to the risk that the file could be wrong. Mistakes are rare, but they can happen. If dividends are announced late, or if complex corporate actions such as mergers or rights issues are mishandled by the administrator – or handled in a different way to the index provider, which has its own guidelines – this can cause a mismatch between the portfolio composition file and the index.

“If the portfolio composition file was wrong, there could be prices quoted that are incorrect. There could be people doing trades at a price that’s slightly off from where the net asset value is,” says Rushe.

Another possibility is that the fund manager who oversees the ETF has “optimised” it, meaning he or she has added or removed securities so it no longer precisely matches the index, but these changes have not been reflected in the portfolio composition file.

Market makers as well as the banks have numerous checks in place and usually alert the administrators to any errors before they cause trouble. But in the event that mistakes slip through, market makers might lose faith in the portfolio composition process, in which case they might add a risk premium into their spreads.

Not every physical ETF provider produces an exact breakdown of the fund’s contents. Some physical ETFs behave more like synthetic products by simply providing market makers with a price that is the net asset value of the fund, plus a spread that reflects the cost of investing additional money.

Rushe says this is more common in the “grey world” of optimised tracker funds, and may happen “if you have a portfolio manager who likes to be a bit more clever about how he achieves his tracking”.

An ETF manager might be trying to track a very broad index of 10,000 stocks, and choose roughly 100 for the ETF. These kinds of products are a grey area because they depend on a form of stock-picking, which is more usually associated with active fund managers, though the intention with optimised ETFs is still to achieve returns in line with a benchmark rather than beat it.

Another motive for not publishing an exact breakdown applies particularly to fixed income products. “Publishing out there a basket that you would either have to buy or sell on a given day, regardless of what the bond market was doing, can be very restrictive,” says Rushe – it may prompt the market to push up prices because of the anticipated demand.

Physical ETFs are set to live on for some time yet. They are perceived to be safer by some investors, who prefer not to be exposed to the counterparty risk that a fund takes when it buys derivatives. The perception that physical products are safer persists, despite many providers of physical ETFs engaging in securities lending to boost their revenues, which also implies a counterparty risk.

The chief source of the administrative complexity attached to physical ETFs, in specie dealing, also looks set to persist. In specie dealing is particularly popular in the United States because it allows market participants to avoid tax on share transactions.

This is not the case in Europe, but many market makers still opt for in specie dealing on some funds because they believe they can obtain the securities at a better price than the fund manager.

©2012 funds europe