24/03/2015. ETF Replication Risks and Performance Now!

Transcription

1 ETF replication risks and performance NOW! 24/03/2015 ETF Replication Risks and Performance Now!

2 Two decades of very serious growth Sources: BlackRock, Koris International, Bloomberg, Reuters. ETF Replication Risks and Performance Now! 2

3 A bright future Growth in the ETP market has been constant and solid, it is expected to remain steady for a number of reasons: Increased demand for core asset allocation building blocks, very attractive and wide product range Need for market access outside trading hours for the underlying assets globally Development of new benchmarks such as smart betas (i.e. non cap-weighted or debt weighted), as well as actively managed ETPs The failing traditional active asset management industry is under tight scrutiny when it comes to delivering performance above the index (less than 20% of mutual funds outperform their benchmark on a persistent basis), putting a strain on active strategies and pushing investors, especially the very large ones, towards passive instruments or more advanced smart beta solutions. ETF Replication Risks and Performance Now! 3

4 A global industry, still dominated by the US In 2003, the global ETP industry managed USD 218bn across 300 products, 70% of which were US registered funds. In September 2014, 5,303 ETPs offered across the five continents represented a stunning USD 2.62Tr, a tenfold increase. However, one thing has little changed: the US still dominates the trackers industry with a 71.2% market share. Sources: BlackRock, Koris International, Bloomberg, Reuters. ETF Replication Risks and Performance Now! 4

5 Now, let s look into the details ETPs in Europe (as of Sept. 2014) European ETPs: 46 providers, 2,219 products, EUR 362bn AuM and 17.2% of the global ETP market. The European ETP market remains highly concentrated with the top 3 providers ishares, db X-trackers and Lyxor ETF managing more than two thirds of the overall assets (ishares holds EUR 166.4bn of assets, a striking 46% market share). ETPs in America (as of Sept. 2014) US ETPs: 58 providers, 1,646 products, USD 1,864bn AuM and 71.2% of the global ETP market. It is much more efficient than the European market though even more concentrated: The top 3 providers ishares, State Street and Vanguard manage the four fifths of the overall assets with market shares respectively equaling 38.1%, 21.8% and 21%. Sources: BlackRock, Koris International, Bloomberg, Reuters. ETF Replication Risks and Performance Now! 5

6 What was supposed to be a simple value proposition ETFs have been designed and marketed as straightforward financial products, perfectly tailored to what investors want: Delta one exposure to large indices; Controlled, cheap and transparent replication costs; Controlled replication risk, short term (price uncertainty) but also long term (drag); Clear legal wrapper; A sense of understanding of what is held, which risks the investments carry beyond market risk. ETFs are a hybrid instrument: 1) funds with a perfectly clear and protective legal environment and 2) an embedded security with all the benefits of active secondary markets. ETF Replication Risks and Performance Now! 6

7 turns out to be fairly complex for investors No clear methodology to differentiate between players, no transparency over ETF quality, no consensus on what should be measured and reported; Poor historical data quality even on subscription-based platforms, not fit for quantitative analysis; Hidden costs embedded in the products, and during the execution cycle. Wide confusion between management fees, total costs of ownership, expense ratio, total expense ratio and swap costs; Misunderstanding by most industry professionals of the meaning of leading performance and risk indicators; New reporting requirements resulting in essential information hidden in annual reports, far from investor s eyes. ETF Replication Risks and Performance Now! 7

8 actually, it turns out to be a nightmare Synthetic vs. Physical war at the heart of extreme marketing games, complex stock lending schemes, financial and legal structuring at its best, tax optimization. with many hidden surprises; Changes in indices, in methodologies, in tracking methods possibly legitimate, certainly impossible to understand and follow for investors; Significant increase in the complexity of indices tracked by ETFs with very little transparency on the financial risks embedded in the variations from market capitalization indices; Secondary market barely alive, absence of post-trade report on trades and associated prices and costs. ETF Replication Risks and Performance Now! 8

9 Leaving the investor with one question: How do I select the best vehicle? Consensus does not exist in the industry on how to respond to this legitimate question. Most professionals suggest to make investment decisions based on the following criteria Tracking error levels Replication framework (physical/synthetic) Fund s Assets under Management Management fee levels Average daily liquidity Issuer market share Even though those criteria are highly relevant, we believe there is a significant risk of being misled by a too restrictive analysis and a lack of verified and homogeneous information. ETF Replication Risks and Performance Now! 9

10 Tracking Error vs. Tracking Difference: What does really matter? Annualised Tracking Error ETF A 5.95% ETF B (outperformer) 0.00% ETF C (underperformer) 0.00% According to Tracking Error, ETF B == ETF C >> ETF A ETF Replication Risks and Performance Now! 10

11 Tracking Error vs. Tracking Difference: What does really matter? Annualised Tracking Difference ETF A +0.72% ETF B (outperformer) +6.93% ETF C (underperformer) -6.95% According to Tracking Difference, ETF B >> ETF A >> ETF C ETF Replication Risks and Performance Now! 11

12 Functional adjustment Technical correction Beware of TE analysis made on raw data ETF Replication Risks and Performance Now! 12

13 1-Year Tracking Error Replication method of the fund and capacity to deliver the index returns 3.0% Tracking Difference & Tracking Error 2.5% 2.0% Direct (Physical) Indirect (Synthetic) 1.5% 1.0% 0.5% 0.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 1-Year Tracking Difference Universe of 200 largest ETFs representing 64% of European AUM ETF Replication Risks and Performance Now! 13

14 Replication method of the fund and capacity to deliver the index returns ETF Replication Risks and Performance Now! 14

15 1-Year Tracking Difference Size as an indication of the fund s capacity to deliver tracking quality 4% AUM & Tracking Difference 3% 2% 1% 0% -1% -2% -3% -4% EUR Assets Under Management (log scale) Universe of 517 ETFs representing 75% of European AUM ETF Replication Risks and Performance Now! 15

16 1-Year Tracking Error Size as an indication of the fund s capacity to deliver tracking quality 4.0% AUM & Tracking Error 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% EUR Assets Under Management (log scale) Universe of 517 ETFs representing 75% of European AUM ETF Replication Risks and Performance Now! 16

17 1-Year Tracking Difference Do fee levels really matter? 4% Expense Ratio & Tracking Difference 3% 2% 1% 0% -1% -2% -3% -4% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% Expense Ratio Universe of 517 ETFs representing 75% of European AUM ETF Replication Risks and Performance Now! 17

18 Impact of fee cuts Can be significant but is it robust? ETF Replication Risks and Performance Now! 18

19 Examples of rolling tracking differences ETF 1 Physical Replication (> $10bn in AuM) ETF 3 Physical Replication (> $10bn in AuM) ETF 2 Synthetic Replication (> $1bn in AuM) ETF 4 Synthetic Replication (< $300m in AuM) ETF Replication Risks and Performance Now! 19

20 GTR, NTR & PI A confusing and dangerous game Difference in total return between the PI and the NTR indices: 1.14% ETF Replication Risks and Performance Now! 20

21 More issues when we look into liquidity ETF Replication Risks and Performance Now! 21

22 What about smart beta? The following graph depicts ETFs tracking the MSCI Emerging markets Index NTR. Over the analysis period*, the index s return was +5.03%. Two smart beta funds are hidden: A first fund reported returns of -0.86% (associated index +1.05%) A second fund reported returns of +7.18% (associated index +7.88%) * Analysis period: 1-year from 28 February 2014 to 27 February ETF Replication Risks and Performance Now! 22

23 Concluding thoughts Understand the index you invest in and widen your universe Holistically assess the funds available i. Counterparty Risk ii. Size relative to your investment s amount iii. Tracking Difference and its stability over time iv. Average Daily Tracking Error and extreme values v. Primary and secondary markets liquidity Stay away from bold conclusions There is no such thing as one size fits all Use independent and verified sources of information ETF Replication Risks and Performance Now! 23

24 The Gate to Exchange-Traded Funds for European professional investors Transparency on ETFs, Now! ETF Replication Risks and Performance Now! 24