What do exchange-traded funds (ETFs) and pricey shoes have in common? Not much until you’ve read Izabella Kaminska’s piece on FT Alphaville about the growing use of derivatives in the ETF space. (I would recommend reading it—whether or not you agree, it’s a great piece of writing.) In ETF phantom liquidity, Kaminska uses Gucci shoes to describe how the use of derivatives in the ETF space impacts the supply and demand fundamentals of different stocks. So, if you think you’re buying shares of a Gucci shoes index fund (i.e., buying exposure to pairs of rare and expensive shoes) and the underlying constituents are actually Nikes and Clarks, you’re not exactly getting what you think you’re paying for. Which, argues Kaminska, is what happens in the case of ETFs that use derivatives to maintain liquidity and meet investor demand for decidedly less abundant types of securities.
Whether or not you agree with Kaminska’s take, her post speaks directly to investors’ (and also regulators’) concerns over the increasing use of synthetic ETFs, which promise to deliver performance without owning the underlying stocks. ETF providers appear to be hearing these concerns loud and clear—and they’re responding. Last week, one of Europe’s biggest providers of synthetic ETFs, Lyxor Asset Management, announced it is bringing out its first range of physically replicated ETFs before the end of the year. “We have a business model with synthetic replication that is efficient, but there are still some investors that prefer physical replication,” said Alan Dubois, Lyxor’s chair.
Synthetic ETFs have played an important role in helping investors gain access to less liquid types of securities using derivatives. But regulators have also voiced concerns about just how complex these ETFs are and the potential impact they could have on the overall market. Investors are responding to the message from regulators: last year alone they pulled record amounts from derivatives-based ETFs and moved it into products backed by physical bonds and shares instead. Lyxor is just one of the firms that has been hard hit.
I wrote last week that 2012 is proving to be a watershed year for the maturing ETF industry—this latest development is another sign that the ETF space is changing in a big way.