ETF firms under scrutiny

The exchange traded fund industry has enjoyed explosive growth, thanks to its promise of low-cost exposure to an ever-widening array of underlying assets. But there are fears that this growth may be outpacing the ability of regulators to keep up with the risks associated with the products.

In Europe, the focus seems particularly sharp on synthetic ETFs, which, unlike physical replication ETFs, use derivatives to provide index returns. The primary concern of regulators overseas is that the ETFs expose the investors to substantial counterparty risk.

This is no-doubt top of mind on The Continent these days, as credit risk threatens to destroy the institutions that most frequently serve as derivative counterparties: the banks. Without proper safeguards, a derivative investment fund can quickly evaporate if the counterparty goes bust.

A recent National Bank report, “ETF Regulatory Reviews & Risk,” cautions that although synthetic ETFs have been far more prolific in Europe than in Canada, “investors need to consider the counterparty risk that’s introduced in these products, both in type and amount.”

There are 13 single long synthetic ETFs in Canada that represent 7% of the total ETF assets in Canada, compared to 3% in the United States and 40% in Europe.

Mark Yamada, president & CEO of PŮR Investing Inc., is on the OSC’s Investment Fund Products Advisory Committee and has a ringside view of the level of ETF scrutiny in Canada.

“I do know that [regulators in Canada] are looking at the derivatives-based and synthetic ETFs the same way that Europe has been looking at them, but the situation in Canada is different,” he says, explaining that Canadian risk management practices are far tighter.

“The part [of the ETF] that is associated with any counterparty risk is limited to only 10%, anything over that and you’d have to get another counterparty,” he says. Canadian synthetic ETFs also differ in that collateral is held entirely in cash.

Increased awareness of ETFs among regulators is not necessarily a bad thing, says Oliver McMahon, director of product management for iShares Canada. He says derivative-based inverse and leveraged ETFs are not badly designed, but were poorly marketed to investors.

In their early days, these ETFs were used as buy-and-hold products, but are designed for short-term trading.

“Investors expected to get one thing and got something quite different, unfortunately, and that’s an opportunity for better regulation,” he said. “Well-crafted regulation should be designed intentionally not to stifle innovation, but poorly crafted legislation can easily become a burden and push firms out of the marketplace or can make it difficult to launch new products.”

If there are growth barriers reining in the global ETF industry, they aren’t obvious. The industry is growing at nearly 25% a year.

ETF providers say regulators are motivated by another—more real—risk: that ETFs are eating into the market share of traditional mutual funds.

“The mutual fund players have an awful lot to lose and they’re being quite aggressive, and in some cases quite misleading, about how they can defend that marketplace, but people are starting to see through that,” McMahon says. “We’re fighting hard to get that changed.”

Michael Cooke, head of distribution for PowerShares Canada agrees. But he also thinks members of the ETF industry are to blame.

“It is [also] coming from ETFs who have vested interest in casting aspersions on synthetically-based ETFs,” he says. “There’s probably even more scrutiny just from the ETF provider community than there is [from regulators].”