As far as Robert Taylor is concerned, exchange traded funds are “the product of the decade”, and that worries him.
Taylor chairs the committee on investment management at the International Organisation of Securities Commissions, which is currently doing a study of the ETF product.
The study is focusing on how much investors understand about the way ETFs work, the role of authorised participants and market makers, the relationship between the product issuer and the investor, and the increasing complexity of the product.
“Things start with simple variations. Then they get more and more complex,” Taylor says.
“We saw this with structured products pre-GFC. Banks ended up having to pay back a lot of capital because customers did not fully understand wat they were getting into.
“Regulators are interested in making sure we do better than we did with structured products.”
He says that since the GFC regulators have taken a more forward-looking approach to their work, spending a lot of time looking at what the risks could be. One question he asks himself is how ETFs would have performed in 2008.
“People in the industry often don’t see the risks emerging,” he says.
“There is a belief in the liquidity of the product and a belief that this product is better and more efficient. But when you talk to retail investors, it is not clear what they think they are buying. They don’t understand the basic arbitrage functions that supports it.”
In a review of the local ETF market last year, the Australian Securities and Investments Commission said the market was “generally functioning well” and is delivering on promises to investors.
However, it detected some potential risks that require monitoring by issuers and oversight by market operators.
In addition to asking issuers to develop policies for dealing with unsuccessful funds, it wants them to do more to inform investors about the tracking error of funds, indicative net asset values and trading spreads.
And it is concerned that there too few market markers providing liquidity in the local ETF market.
ASIC says: “ETF trading is generally liquid, bid-offer spreads are narrow and secondary market prices are generally close to the NAV is ETF units. However, this does not necessarily apply to all products at all times.”
“In particular, we observed that spreads do temporarily widen in some circumstances, meaning individual transactions may involve a higher spread than an investor may consider desirable. The spread may significantly affect investor return.”
ASIC has recommended that ETP issuers make indicative net asset values available to investors, which would allow investors to assess the reasonableness of an ETP’s market price. It also wants issuers to provide investors with education about the existence of iNAVs and how to use them.
An iNAV provides a reference point for investors to assist them in understanding if they are purchasing or selling ETPs at or close to NAV.
ASIC says that at the moment issuers do not have a consistent approach to publishing iNAVs. The majority provide iNAVs for Australian equity and fixed income ETPs but not for any international equity or fixed income ETPs.
ASIC wants issuers to disclose both tracking error, which measures the quality of index replication on a day-to-day basis, and tracking difference, which provides a longer-term view of the performance of the ETF against the target index.
It
wants market operators, such as the ASX, to monitor the liquidity commitments
of market makers more closely. A market maker provides liquidity for an ETP
where it does not have sufficient “natural liquidity” to function efficiently.