ETF strategy: beware the overlooked risks of tracking error

Although counterparty risk has been at the fore of the debate surrounding exchange traded funds (ETFs), regulators have ‘overlooked’ a range of issues including tracking error that wealth managers should take into account.

According to Noël Amenc, director of the Edhec-Risk Institute, regulators focusing on the improvement of counterparty risk mitigation in ETFs, or the possible systemic risk implications of these products, are not paying enough attention to other performance issues.

‘By directing their thoughts and attention to the regulatory improvement of counterparty risk mitigation in ETFs, we believe regulators have overlooked a first-order issue, the comparability of performance among ETFs,’ he said. ‘

In particular, Amenc said it is crucial that key investors are given information on the total return generated through the risks assumed on their behalf by funds, such as the benefits from securities lending.

The institute also regards it ‘essential’ that indexing vehicles are required to disclose tracking error targets and results.

‘While index funds have grown on the back of passive management, there is no standardised measure or mandated disclosure of the quality of index replication at the European level,’
Amenc said. 

‘In the same spirit, we consider it is critical that regulators give a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes, which after all remain the main drivers of the financial risks assumed by ETFs,’ he added.

Assess the risk

Wealth managers looking to buy an ETF must assess the underlying index, which provides the relative exposure to the respective market or asset class.

Traditionally, indexes are market cap weighted, but increasingly new types are coming to market, with different methodologies, such as fundamental indexing. There are also proprietary types of indexes being created, which can offer an enhanced methodology, drawing from an existing index.

Ossiam, the investment arm and ETF provider of Natixis Global Asset Management, recently launched the FTSE 100 Minimum Variance fund, which tracks an index comprising the most liquid FTSE 100 stocks while aiming to mitigate volatility. While investors must look at the underlying index in order to determine how they are gaining exposure to the market, counterparty risk is still nonetheless an important issue, although Edhec believes the angle of focus on this area is skewed.

Finding a competitive edge

Amenc said several product providers are looking to strengthen their competitive edge within the fast-growing and profitable ETF market, by informing investors and regulators of counterparty risk stemming from the use of swaps – or over-the-counter (OTC) derivatives – by synthetic funds.

He said some providers have also emphasised the distinction between unfunded and funded swaps, suggesting the latter offer better protection against counterparty risk.

‘However, any Ucits can take on more unmitigated counterparty risk through securities lending than via OTC derivatives, and physical replication ETFs – unlike their synthetic counterparts – routinely engage in securities lending,’ he added.

‘These false distinctions may lead investors to pay less attention to first-order issues that determine the effective mitigation of counterparty risk: the quality of the assets performing the economic role of collateral and the ability of the fund to enforce its rights against collateral in the case of default by the counterparty.’

Keeping things transparent

In this sense, while issuers are being transparent in disclosing the nature and level of their collateral holdings, wealth managers need to ensure they check the collateral composition of their ETFs, not only for swap-based funds, but those physical products that do securities lending.

Amenc said: ‘Interestingly on these two counts, there is little in the way of European guidelines governing the taking of collateral to mitigate the risk from securities lending and specialists recommend the use the robust standard master agreements to deal with the legal risks arising from the activity.’

Nonetheless, iShares is one of the issuers that is transparent in its securities lending process, which has independent oversight provided by BlackRock’s Risk and Quantitative Analysis Group.

This group monitors the counterparties, the counterparty limits, as well as the levels of collateralisation, on a daily basis.