Amid the cluster of ETF providers, Source found a gap in the market. Developing a product to be used by hedge funds to short stocks has been key to the firm’s business. Angele Spiteri Paris speaks to CEO Ted Hood.

With so many ETF providers active in Europe, relative newcomer Source knew it had to bring something different to the table if it had any hope of success. And chief executive officer Ted Hood thinks the firm has accomplished this.

Hood explains how Source found a gap in the market that other providers could not fill. Hood says that with the ETF, the firm has given the hedge fund community a trading tool that is more efficient than the swaps they used historically, and this helped the European ETF market grow as a result. He says that Source was not interested in setting up in Europe and “stealing” assets from other ETF providers since that would have been counterproductive.

“Our aim was to help grow the European ETF market so that there would be sufficient assets for all the players,” he says.

The seed for Source’s idea to boost the ETF market lay in a comparison of the European industry with that of the United States.

Hood says: “One thing that was dramatically different was turnover – the US market has tremendous turnover in ETFs and the correlation between when that turnover started to appear and when assets started to grow was pretty direct.”

Therefore, the key to growing the European ETF market, according to Source, is increasing the turnover. “If the numbers in the US were telling a story – that turnover begets more AuM which begets more turnover which begets more AuM – then the way to kick-start the European ETF market would be to do something about turnover,” he says.

And Hood and his colleagues realised that the major driver of that turnover in the US was the use of ETFs by hedge funds. He explains: “In the States, hedge funds are using ETFs very significantly. They are responsible for roughly 30% of all ETF trading there. Making money shorting individual stocks is a very frightening thing to do because you can lose an infinite amount of money. So it’s common for hedge fund managers to use ETFs solely as a hedge.

“They would buy a long position and they will hedge the market by borrowing and shorting an ETF, or they will  take a short position and hedge their market exposure by going long on the ETF. For example, if they had a positive view on Apple, but not on the tech sector as a whole, they would buy Apple and short the tech ETFs.”

But in Europe this wasn’t happening. Before Source was created, the turnover of ETFs was very low and hedge funds were using swaps to exercise their short positions instead of ETFs.

So the first question Source asked was: why were hedge funds using swaps when ETFs would make their lives a lot easier?

Swaps versus ETFs
Hood says: “Swaps are difficult. They provide concentrated counterparty risk, they’re painful from an operation standpoint and they’re a bespoke instrument so banks have to know where you stand. With this in mind, hedge funds would have a strong preference to execute in an ETF format, so why aren’t they doing so?”

Actually, he found that there was a structural problem in the European market. One cannot borrow an ETF in Europe for a reasonable amount of money, which Hood says, “is fundamental if you’re going to short”.

He explains further: “In the US, if you want to borrow a SPDR ETF [an ETF that tracks an S&P index] you can do that for about 30 to 40bps a year and that price is pretty much always the same and always available.

“If you wanted to borrow a EuroStoxx ETF in Europe, it would cost you up to 2% a year and you might not find that much of it to borrow.”

So how to solve this dilemma? Source found that because of the way the market was constructed and because the first ETFs in Europe were physically-backed, the US initiatives to drive down cost and create ETF securities for hedge funds to borrow could not be replicated in Europe.

In the US, the practice known as “create-to-lend” is widespread. This sees investment banks creating ETF units and, therefore, incurring upfront capital costs.

This could not be duplicated in Europe with any amount of ease. Hood says: “Ten years ago people were looking at it [the create-to-lend market] in Europe and found a whole host of problems, mostly related to the fact it was very impractical for physical ETFs to create-to-lend since it was extremely expensive and people thought it would never work.

“We looked at it and found that if you construct a product properly, you can fix some of these issues and actually make this process work. But in order for that to happen you need buy-in from a significant part of the trading community.”

Therefore, Hood explains, that to create an ETF product that can be traded and borrowed more efficiently, one needed a number of banks to co-operate.

This is why Source is mainly a result of partnerships. The firm has partnered with leading investment banks such as Bank of America Merrill Lynch, Goldman Sachs, JP Morgan, Morgan Stanley and Nomura, to name a few.

As a result of Source’s injection into the European ETF market, it had a profound effect on the turnover in European sector ETFs.

According to Cascade, the German clearing system, since the launch of Source European sector ETFs in July 2009, monthly turnover for the European Sector ETFs increased by more than 650%. In March 2011, Source Optimised Sector ETFs captured 77% (€10.6bn) turnover share of volumes reported in Cascade.

But although Source identified the opportunity, making it work was easier said than done. Hood says: “We spent a long time working through the kinks to make sure the process works. The theory was, very simply, if you get something that was more liquid and easier to trade, then people would buy it.”

Another obvious question is why none of the other providers swooped in before Source, considering some have been active in Europe since the early days of the ETF market.

According to Hood, one of the major issues with other providers trying to do what Source has done is that several of them are linked to banks.
He says: “You’re not going to have one bank go to another and say, ‘I want you to change the way you do business so I can make more money.’ This is the kind of issue Deutsche  Bank and Lyxor would have had; they couldn’t convince the market to come round and help them.”

Physical process
The other ETF behemoth is iShares, but Hood says: “iShares is very committed to the physical process and, in Europe, this is not conducive to the create-to-lend activity. For example, if there are UK equities in  a product, then you have to pay stamp duty on them and the economics of shorting are very tight. Therefore, if you can short a swap for three basis points and not pay the 15bps in stamp duty to execute, you’re going to stay on swap.”

Despite the effect Source’s products have had on the turnover levels within the European industry, the $9.bn (€6.2bn) the firm raised in assets is not directly linked to the hedge fund activity. Hedge funds, it seems, are drivers, but they are not the bulk holders of assets under management (AuM).

“Hedge funds matter because trading drives spreads and makes the market more efficient. The hedge fund activity in the European ETF market does not represent the increase in AuM. They represent the trading volume and they provide massive amounts of liquidity,” Hood says.

So who holds the assets Source has accumulated?

“We estimate that roughly 80% of assets come from institutional clients versus 20% from hedge funds and retail.”

©2011 funds europe



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