Exchange-Traded Funds (ETFs) have democratized the process of owning a diversified portfolio. “Nowhere else in the financial services industry do we have institutional and retail investors treated the same,” Som Seif, CFA, said at the 3 April 2012 seminar on ETFs held at the CFA Society Toronto offices. (The course was also offered in October 2012 and will be offered again in spring 2013.)

The ETF industry is growing at a fast, some might say alarming, pace. According to the Financial Stability board, ETFs, first introduced in 1993, mushroomed to $1.2 trillion in global assets under management at the end of Q3 2010. Of these assets, 85% are plain-vanilla ETFs referenced to equity indices.

Secondary market liquidity a big piece of the puzzle says Marty Gillespie

Seif spoke with great enthusiasm about a class of financial product that has been growing by leaps and bounds. He knows the industry and its growth rate intimately—he founded ETF provider Claymore investments (headquartered in Toronto) in Canada in 2005 and sold it to Guggenheim Partners (headquartered in New York and Chicago) in July 2009. In March 2012, the Canadian subsidiary of BlackRock (headquartered in New York) closed its acquisition of Guggenheim’s entire interest in Claymore.

BETA CAPTURE

“I wanted to do things right,” said Seif in describing his initial vision for Claymore. “We entered [the market] with a different idea about investing. We did not want to ride the coat-tails,” he said, referring to Claymore’s strategy. “We were providing bottom-decile fees in return for first- and second-quartile performance.” The juggernaut company grew to nearly $8 billion in assets under Seif’s management, making it one of the fastest growing companies in Canadian history.

ETFs represent “the most cost-effective beta capture,” Seif said. in his view, there are three basic principles underlying an attractive ETF investment fund, and they all are connected to what creates value: fees (the lower the better), good net after-tax returns, and removing the irrational human element from decision making. ETFs are a multi-purpose tool that can be used by any type of investor. Seif emphasized that ETFs are “a structure, not a strategy.” Over the past five years, the industry has seen a proliferation of products, including commodity ETFs, sector-specialized ETFs, and synthetic ETFs, created from derivatives and swaps.

Seif acknowledged that there has been a lot of “noise” lately about ETFs, citing John Rubino’s article in the September/October 2011 CFA Magazine, “Emerging Threat Funds?” Three major regulators (the International Monetary Fund, the Financial Stability Board, and the Bank for International Settlements) have all highlighted ETFs in recent notes or working papers.

With so much of the trading market moving toward ETFs, regulators are looking at the systemic risk of these products. In Canada and the U.S., ETFs are regulated by mutual fund legislation. Canada limits the use of swaps and derivatives in the products and every fund must be cash collateralized. A key difference between Canadian and U.S. ETFs is that a Canadian fund can only lend out 50% of its portfolio. Stateside, however, a fund can engage in third-party lending and lend up to 100% of its portfolio.

The greatest “noise” Seif referred to arises from four issues he believes should be cleaned up: swap-based ETFs, ETFs using derivatives, securities lending practices, and leveraged and inverse ETFs. In Europe, the use of the ETF structure has looser guiding principles. For example, some bank-owned European ETF providers were collateralizing their portfolios with junk-grade assets. Fifty percent of the market was swap-based, yet the swaps were not structured right, and the counterparty risk was high, he explained.

ABOUT LIQUIDITY

In ETF trading, liquidity is not a function of volume but depends instead on the liquidity of the underlying securities, explained Seif. The designated broker sets up “goalposts” of bid/ask prices, and this means investors can buy or sell at any time. The ETF acts as a conduit, and the market maker has an auto-trader that will immediately buy or sell the stocks. The designated broker keeps the market price close to net asset value (NAV) throughout the day and is motivated to keep the bid/ask spread tight. “[Brokers] all want volume,” said Seif, explaining that the broker is long on ETF units and stays 100% hedged through short positions on the underlying portfolio.

There are thousands of bid/ask spreads listed. When the investor sells the ETF, the designated broker goes long the underlying stock. The broker might have a fluctuating inventory. There might be no activity in the fund itself, but the stock prices might be volatile. ETFs are often more liquid than ordinary stock, even for blue-chip corporations. Claymore devised preferred share ETFs that, at $800 million, were the largest in the field; concurrently, the underlying portfolio was illiquid.

Seif shared three important ETF trading tips:

1. Liquidity is lowest at the open and close of trading, so traders should avoid trading in the first and last 15 minutes.
2. A trader should use limit orders and avoid market orders wherever possible.
3. A trader should focus on the bid/ask prices—not the most recent sale—as the “current market price.” In evaluating the indexed funds, Seif briefly described three broad categories of weighting used: market cap, equal-weighted, and fundamental-weighted.

Seif: “Low cost, low turnover, and transparency are the winning features of ETFs. Active funds will have higher costs… [so] why bother?”

THE FUTURE

The industry is moving toward a combination of active and passive investing strategies. Seif is bemused by the growth of active ETFs. “Low cost, low turnover, and transparency are the winning features of ETFs. Active funds will have higher costs … [so] why bother?” Similarly, leveraged and inverse ETF products are more “challenging” and should be evaluated for appropriateness of use. He predicts the non-vanilla funds will continue to attract regulatory attention.

ETFs’ NIGHT OUT

Evening session focused on liquidity, trading, and strategies.

On 13 September, an evening information session at CFA Society Toronto called “ETFs: Liquidity, Trading & Portfolio Implementation Strategies” featured three speakers panels and lots of informal networking at the Hockey Hall of Fame. “Liquidity” appeared to be the catchphrase of the night, and moderated discussions covered market making, liquidity and trading, the use of Bloomberg to analyze and evaluate ETFs, and tactical ETF asset allocation.

Constantin Cosereanu, CFA, showed several features of the new Bloomberg ETF module, such as the “appropriations” section, which tells at a glance whether a given ETF has leverage, is actively managed, is swap-based or derivatives-based, and so on. The “basket liquidity” feature shows how many shares of a given ETF can be added before affecting liquidity. Other ETF module features include: implied liquidity analysis, intraday P&L, concentration reports, calculation of risk exposure relative to a benchmark, key stats, stress testing of a portfolio with custom shocks, fixed income ETFs, and ETF flows and trends in flows. Emmanuel Baror, CFA, followed up with worked examples of ETF options via Bloomberg.

Another panel member, Pat Chiefalo, CFA, from National Bank Financial, said that his bank is increasingly advising a growing number of institutional clients on ETF analysis and recommendations for exposures on specific geography, asset class, and sector. This includes asking market makers for liquidity profiles and bid-ask spreads as part of their liquidity analysis. Marty Gillespie, from RBC Capital Markets, concurred that “secondary market liquidity is a big piece of the puzzle.” The index an ETF is based on is key to driving its behaviour, he noted.

Jeremy B. Beck, from Nottingham Advisors, told a compelling tale of liquidity when, in the 2007 market, his firm suddenly became the world’s largest holder of timber ETFs. After some “very long days,” the potential illiquidity was resolved. The moral of the story, he said, is to consider the ETF provider “as a support if you need help unwinding. There are market makers out there who are deconstructing markets very efficiently.”