Funds Europe – The Central Securities Depositories Regulation (CSDR) regime is set to come into force next year. What are your thoughts on the proposed settlement penalties for ETF issuers, and their impact on the primary market?
Dzanis – This is a very hot topic, and there are differing opinions. The concept of harmonisation would be beneficial to ETF users, especially for clients who are settlement-sensitive. The buy-side says it’s a big positive, however there are a couple of potential unintended consequences from this directive that would have less flexibility for the sell-side. They have to come on the primary market to cover buy-ins. The creation costs could increase alongside ETF prices, which means potentially wider spreads, and so that could lead to an increased cost for the end investor.
The other issue around this, which is an interesting dynamic too, is Brexit. Now the UK has left the EU, it is considered a third country. The interesting dynamic is that if I now execute a trade on the London Stock Exchange and it’s settled in Euroclear, I’m going to be in scope, but if I did it OTC and settled in Crest, I’m out of scope.
The consistency and the process of potential settlement and fragmentation – where there’s lack of consistency – presents more risk.
Guthrie – It’s going to add cost, no doubt about it. You’re extending penalties to an element of trading that represents more than 60% of the market. There’s going to be added cost there, and that’s going to pass through to the end client. That said, this is levelling the playing field and reducing fragmentation from a trading perspective. The costs of clearing are already passed through on exchanges, that filters into what people pay in the buy-ins, etc, so why isn’t that also in the OTC space? Levelling that out allows people to make better, more informed choices on what their trading preferences are.
Choice has led behaviour more so than maybe the best trading outcome has over the past half a decade. Levelling that playing field out isn’t inherently a bad thing. We’re not going to roll back things that have already happened, but it will allow innovation to happen on a more level playing field, on a cross-execution basis.
Shastry – If the issuers are facing any issues with an AP and they don’t settle, then the issuers are going to be penalised now because they are failing, as they’re trying to protect the fund by not taking on counterparty risk.
Sorel – And there are a few nuances here as well that are not yet taken into account, on the specificity of the ETF that can trade while underlying markets are closed, leading to longer settlement periods.
Shastry – There is a delay available for settlement within the CSDR, though. For example, they could have Chinese New Year where they might be closed for a few days, or in some markets in the Middle East if a royal family member dies there will be a few days holiday, etc. But all these issues, and the impact of them, haven’t been considered in full.
Guthrie – We do a lot of in kind creations because of the physical commodity side of the business. We would never let shares be released to an Authorised Participant if the in kind delivery of gold fails. We’re not going to put a counterparty risk into the fund because our fiduciary responsibility is to protect our existing investors.
Shastry – Efama and some issuers wrote to that effect, mentioning that primary market orders should be exempt, ETFs and ETCs.
There are some sell-side institutions that are asking for a level playing field and asking the regulator to treat all in the same way, because how would the clearing house know if a broker sold a product on an MTF [multilateral trading facility] whether you’re creating in the back end or offsetting in the secondary market? The broker might say, ‘I’m failing on the MTF because the issuer’s failing to me.’ The issuer might say, ‘I’m failing because the AP is failing in the underlying basket.’ For the clearing house and regulators, it will get difficult to close the loop, because the sell-side says it’s the issuer, the issuer says you’re not settling in the underlying security, and then the broker says the securities are unavailable because the underlying market’s closed, and the regulator struggles to understand the situation.
Guthrie – Now, if they have a failing counterparty, that’s still their problem, the counterparty is going to get bought in, so that’s kind of their thing. If it’s a cash order, then you’re going to settle DVP [delivery versus payment] anyway, in which case it’s no problem, so all you need to do is carve out the in-kind creates and we are golden.
Funds Europe – Thematic ETFs drew in record inflows last year, but the mortality rate of such strategies is generally high, with around 80% of themed ETFs launched before 2012 shut down. As certain themes such as tech and water tend to be more robust than others, how might this affect the market? Is there a risk of the market becoming saturated with similar-themed funds?
Backreedy – You need to do due diligence on thematic ETFs to understand what the criteria is. What is the fund manager like, their track record, their AuM [assets under management] within the funds? If there’s a strong need to get exposure to a particular theme, they may be flexible on issues like AuM, especially if the fund is relatively new. There are many nuances to take into account.
Guthrie – Thematic ETFs offer an efficient toolset for people trying to make a play or make alpha in their portfolio. It’s an area that a lot of people are trying to get into in name alone, so it’s important to look at what’s in the ETF beyond name alone. We’ve seen a lot of people put out cloud-computing products and they’re full of Google and Amazon. It’s a low barrier to entry, as you can put a label on a product and say you’re doing a thematic fund. For that reason, you’re going to see a high degree of atrophy in that space as the market convalesces around, ‘What’s the approach that we want? How specific is this? How broad is it? Are we testing this out?’
There’s a cyclical nature to thematics. Not everything can be in vogue forever, and as a result you’re going to see closures. The idea of a little bit of creative destruction in the product space is not inherently a bad thing. If we could only launch products that were a guaranteed 100% winner, it would be a very easy industry, but we do have to go out there and try new things. This product set is more susceptible to market cycles than the S&P 500 is going to be.
Backreedy – Another reason that they go into the thematic market is because it’s niche, there is a bit more demand there, whereas in your vanilla core space, you can’t break into that: it’s already saturated. It’s an area where the fund provider can see potential growth.
Schmitz-Esser – We see a lot of demand from wealth managers for thematics. Themes are much easier to communicate than factors or smart beta.
There are challenges on the index side, though. There is a clear trade-off between keeping the index concepts pure play on the one hand and ensuring their liquidity on the other hand. The purer the play, the more challenges there are with the liquidity. A lot of money has been invested in thematic ETFs, therefore we are seeing many typical constituents of thematic ETFs with very high valuations.
Garcia Puente – For certain themes, we prefer ETFs as it’s relatively quick to get exposure to the market. It’s also worth mentioning that there are currently more indices than stocks in the market, so it’s very easy for ETF managers to create or to replicate new themes.
There are some themes that are very interesting, but we live in a changing world. Changes happen very quickly, and some of these crowded themes like water or clean energy are evolving themselves every day. Some of them may consolidate and others might disappear. It’s survival of the fittest.
Sorel – Thematics used to be ten-year horizon megatrends you would only sell to wealth advisers through storytelling. The world changed in 2020 for thematic investing. If you look at the last 12 month’s flows into thematic ETFs, the top ones are clean energy, healthcare innovation, digital security, cyber security, and video gaming. With the working-from-home environment, those themes became an extension of how investors used to think about different broad market sectors, and they are basically a new way to build portfolios with a sector bias. Thematics are now part of all our clients segment portfolios – the universe is much broader in terms of what you can target.
Thematic investing is prone to both active and indexing. If you want to build an active fund, you take a large universe, such as the future of transportation, and buy a concentrated portfolio of stocks. If you want to build an index, you narrow the universe, for instance to electric vehicles, and broaden the portfolio to everything that fits through the value chain from a revenue threshold.
Very narrow time-sensitive themes will die out. We’re trying to anchor the themes towards megatrends: themes that will be there in ten to 15 years. An example: working from home is a perfect theme today, but how will it be in five years’ time? No one has a clue. You can play the same theme on a longer horizon, talking about individual technologies for instance.
Shastry – You basically break a certain idea/consideration into different buckets. Rather than taking work from home as a theme, you break it down into different buckets and then you launch products on those megatrends that could have more longevity. The client base is getting broader now Generation X, Y and Z are taking up investing and people are paying more attention to what they’re doing and the developments. Themes might become sector plays rather than a pure thematic angle.
Dzanis – I think we need to be promoting longevity. Zooming out from a trend standpoint, timing is such that with fee compression, and desire to be unique coupled with need for speed to market can be a compromise. We need to ensure that products have sound investment theses as to get the right outcomes for clients.
It’s not just about academia, you need the ability to manage through multiple market cycles. There is a balance of speed to market with products and wanting to create products and be different and distinct. Investor trust implies that the investment thesis needs to be solid when we’re creating these products, no matter what they are.