The controversy over exchange-traded funds (ETFs) has grown so intense that iShares, the BlackRock-owned ETF giant that leads the market with about a 40% share, has released a public report calling for greater transparency and regulation.
The reputation of ETFs has suffered from association with the UBS rogue trader scandal, which prompted criticism, mainly from the actively managed industry, that accused the instruments of carrying systemic risks.
iShares' report concedes that critics are right to be wary of synthetic ETFs, which do not hold physical securities but gain exposure to them with derivatives. The firm accepts there has been a dramatic increase in the complexity of ETFs and says regulation has not always moved in step with these changes.
iShares' solution is a clearer labelling system and a more consistent regulatory regime that will force providers to disclose the fees and counterparty risks of their products.
The firm says products that are designed only for professional or short-term investors, such as ETFs that use leverage or inverse strategies, should not be allowed to use the “ETF” label.
ETF providers should aim to provide a clear picture of what the fund contains every day, including its counterparty exposures in the case of synthetic products.
Good derivatives practice, continues the report, is to deal with multiple, unaffiliated counterparties and to over collateralise with liquid and diversified collateral. Not every ETF provider follows this rule. Some deal exclusively with an investment bank partner that may also be their parent company.
The guidelines also cover ETFs that add to their income by lending securities in exchange for a fee. Securities lending has caused controversy and many investors have said they were unaware that ETFs engaged in the practice. But the report says securities lending is permissible providing funds disclose all fees connected with the deals and employ independent risk managers.
If the collateral supplied in a securities lending deal is cash, this must be managed in a low-risk strategy by an experienced, stable investment manager, says the report.
Finally, the report calls for greater fee transparency. In addition to the management fee, ETF providers should disclose all costs paid to swap counterparties and securities lending participants.
©2011 funds europe