Back in 1989, when the first ETF rolled into the marketplace in Toronto, it was a pretty straightforward beast. Called the Toronto Index Participation Fund (TIPs) it was linked to the performance of Toronto’s biggest and most liquid stocks. However, as with all good things in the investment industry, ETFs have subsequently been twisted, pulled and pushed into many new shapes and sizes—some good, and some clearly not. Now, terms like counterparty risk have entered into the ETF lexicon as the industry booms and grows at a rapid pace.
Which is why the world’s biggest ETF provider, BlackRock, has just issued a paper calling for uniform regulation of ETFs along with a healthy dose of better disclosure and transparency. To find out more I talked to Mary Anne Wiley, Managing Director, head of distribution for BlackRock’s ETF business, iShares, and she spoke to me about counterparty risk and why investors should demand more upfront transparency around costs.
CC: I have an obvious question up front—you’re the world’s biggest ETF provider. Why is a manager like BlackRock calling for increased regulatory scrutiny of a product you sell?
MAW: We really believe in the integrity of the product and the structure. We think a level of clarity needs to be brought to the category in order to maintain the standard going forward. In fact, I think the industry should demand this.
When ETFs were first launched, they were pretty straightforward and easy to understand—now ETF investors have to worry about counterparty risk. Why is counterparty exposure now part of the ETF landscape?
The ETF category is growing rapidly and product structures are evolving. Today we’re approaching 3,000 ETFs worldwide and with that many products there are going to be differences—not all ETFs are created equal. In my view, innovation has outpaced investor education. When the first ETFs were brought out, they were more homogenous, they held physical securities that were based on broad domestic segments of equity markets.
One key differentiator is the structure being used. Some ETFs now use derivative instruments and swaps which introduce new risk profiles—counterparty risk being the largest and most obvious.
Some synthetic ETFs appear to make good sense for pension plans—for example, ETFs that address longevity risk. Does this mean pension funds should avoid some of these new innovative ETFs?
When you have proliferation and lots of different providers, they won’t all be of the same quality. The point that is important for all investors is that we need clear labelling of product structure. In many ways the ETF space today reminds me of where hedge funds were 10 years ago. People were asking, “What is a hedge fund?” —it became a big banner covering different things. Some hedge funds were good, some were bad—some even had high profile blow-ups. We want to prevent ETFs from going down this route. Right now there is a lack of clarification about what they are and what you’re buying. There needs to be stricter and clearer definitions around product structure. Not everything should be called an ETF—for instance, some products currently using the ETF label should be called exchange-traded notes (ETNs).
What questions should investors ask about counterparty risk?
The same best practice stands: you want to know what you own. For ETFs there will be a prospectus with all the information—take the time to have your lawyers look at it and talk to the ETF sponsor. Ask them whether or not there are derivatives or are they physically-based? If there are derivatives, ask what type: futures, options, swaps? When it comes to swaps in particular, ask questions about how potential risks are being handled: how many counterparties are involved and what is the quality of the collateral?
You also call for more transparency around the total costs. Why? And what questions should investors ask in the absence of transparency?
Costs come in many forms. ETFs have topline MERs, but when you’re getting into swaps, etc., there are embedded costs in those arrangements. They need to be laid out so investors can assess whether they are appropriate. It’s a matter of transparency. They need to make explicit what the total cost of the product is. Right now there is no clear alignment around this. You can find out these answers by digging through a prospectus—but we are calling for costs to be more drawn out and more readily accessible so ETF investors can clearly see the total cost of the exposure they are taking on.