views

NEW BREED OF ETFS SPREAD DEFAULT RISK

MARK WEEKS
CHIEF EXECUTIVE, ETF EXCHANGE

FOLLOWING the financial crisis and the collapse of Lehman Brothers, investors are more keenly aware of the problems that can ensue if a financial institution were to collapse. Those using passive investment tools such as exchange-traded funds (ETFs) are also more conscious about liquidity and index replication.

ETFs have existed for many years, and in various forms that have evolved to cater to investors' needs. First-generation ETFs were the original, physically-backed ETFs which suffered from tracking errors, meaning that their performance did not replicate fully the movements of the underlying index.

This tracking problem has been addressed by second-generation ETFs – these are swap-backed and provided by an investment bank as opposed to an institution such as State Street. The investment bank would guarantee the return of the index, making it a more efficient method of trading for the investor. However, second generation ETFs still retain the problem of only having a single counterparty and post-Lehman, this has been a concern for investors.

Enter third-generation ETFs, which have recently been introduced by ETF Securities. These use the swap-backed ETF model, meaning that each ETF is backed by multiple investment banks.

If one were to default, as Lehman did, we are able to close out the affected bank and reopen the position with another. At the moment, there are three banks (Citigroup, Bank of America-Merrill Lynch and Rabobank) backing the ETFs on the exchange and we expect to add another two banks in the coming months.

This is advantageous for the investor because not only is the product fully collateralised, there should also be better liquidity. Rather than five investment banks all creating their own ETFs, the assets under management (AUM) can be consolidated into one ETF. Investors still use AUM as a guide to the liquidity of the product even if the liquidity of the underlying index is actually a better indicator.

Equally, having more AUM can be attractive as it gives investors the security of knowing that there are other people buying the product. Once the AUM has reached a certain threshold, institutional investors will get involved. This further increases liquidity, and attracts more smaller investors.

Looking forward, the performance of an ETF will be one of investors' foremost concerns. As memories of Lehman fade, they will be less concerned about counterparty risk and investors will be able to more carefully compare the performance of ETFs against each other.