hidden risks in etfs
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8/9/2019 Hidden Risks in ETFs
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© 2010, Morningstar, Inc. All rights reserved.
Hidden Risks in ETFs
Ben Johnson
ETF Strategist
Bradley KayAssociate Director, ETF Research
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A Primer on Counterparty Risk
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What Is Counterparty Risk?
A ³counterparty´ is simply the other party to afinancial contract, typically an investment bank,insurer, or financial exchange
³Counterparty risk´ refers to the chance of the other party in a financial contract defaulting while stillowing money
This is a key source of risk in a fund or investmentportfolio that may not be obvious at first glance
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Sources of Counterparty Risk
The ETF category includes a number of unique fundstructures which have different degrees of counterparty risk
There are four main potential sources of counterpartyrisk in an ETF investment
Swap counterparties in synthetic ETFs
Securities lending in physical ETFs The subordinated debt status of ETNs
Central clearinghouses/exchanges in somecommodity ETFs and ETCs
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Key Points for our Discussion of Counterparty Risk
What are its sources?
Are investors being compensated for this additional
source of risk?
What can be done to either mitigate this risk or makeits potential sources more transparent?
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Synthetic Replication ETFs
Owners of ETFs that use synthetic replication areexposed to the risk that the fund¶s swap counterpartywill fail to deliver the return of the reference index
In return for taking this risk, the synthetic replicationtechnique offers superior tracking relative to physicalreplication funds
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Synthetic Replication ETFs
Swap-based fund providers seek to minimise thelevel of counterparty risk faced by shareholders bymandating collateral requirements in excess of UCITS-mandated minimums
In the event of a default by the swap counterparty,the composition of the collateral basket becomes acrucial consideration
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Synthetic Replication ETFs
The collateral basket may bear little resemblance tothe fund¶s reference index.
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Synthetic Replication ETFs
Name %of Net Assets Name %of Net Assets
Asahi Kasei Corp. 0.41 Mizuho inancial Group Inc. 0.47
Astellas Pharma Inc. 0.81 Nippon Mining Holdings Inc. 0.40
Central Japan Railway Co. 0.85 Nippon elegraph & elephone Corp. 1.04
Chubu Electric Power Co. Inc. 0.75 Nitto Denko Corp. 0.73Dai Nippon Printing Co. Ltd. 0.86 N DoCoMo Inc. 1.03
Daiichi Sankyo Co. Ltd. 0.53 Osaka Gas Co. Ltd. 0.19
Denso Corp. 0.33 Panasonic Corp. 1.44
East Japan Railway Co. 1.21 Panasonic ElectricWorks Co. 0.32
UJI ILM Holdings Corp. 0.86 Shionogi &Co. Ltd. 0.68
Itochu Corp. 0.97 Sumitomo Chemical Co. Ltd. 0.81
Kao Corp. 0.45 Sumitomo Corp. 0.62
KDDI Corp. 1.67 Sumitomo Heavy Industries Ltd. 0.34
Kubota Corp. 0.31 akeda Pharmaceutical Co. Ltd. 0.74
Kyocera Corp. 1.48 okyo Electron Ltd. 0.62
Marubeni Corp. 0.43 okyo Gas Co. Ltd. 0.50
Miraca Holdings Inc. 0.36 oshiba Corp. 0.36
Mitsubishi Corp. 3.29 oyo Suisan Kaisha Ltd. 0.43
Mitsubishi Estate Co. Ltd. 1.42 oyota Motor Corp. 2.77
Mitsubishi Rayon Co. Ltd. 0.32 West Japan Railway Co. 0.60
Mitsui &Co. Ltd. 1.06 OT AL 33.28
Mitsui udosan Co. Ltd. 0.82
MSCI Japan?
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Synthetic Replication ETFs
Not quite
As of December 31, 2009 the collateral basket of db
x-trackers EURO STOXX 50 ETF was comprised of amix of blue chip equities, including a 33% allocationto Japanese shares
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Synthetic Replication ETFs
Interim disclosure of the composition of collateralbaskets is already taking place on an on-demandbasis
Regular disclosure of the composition of thecollateral basket would be, if nothing else, a sign of providers¶ commitment to full transparency
Over-collateralising and engaging multiple swapcounterparties can help to mitigate counterparty risk
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Physical Replication ETFs
The chief source of counterparty risk in physicalreplication ETFs arises from securities lending
Investors are compensated for taking this risk in theform of additional income to the fund
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Physical Replication ETFs
Possible default by borrowers
Risks tied to reinvestment of cash collateral held by
lenders
Greater transparency surrounding securities lendingpractices and the portion of income generatedthrough securities lending that is shared with thefund¶s owners would help investors to make moreinformed decisions
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ETNs
Exchange-Traded Notes
Debt instrument issued by a backing bank
Senior, unsecured debt of that bank
Substantial counterparty risk
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ETNs
The ETN is not a very popular vehicle in Europe, withonly two issuers currently offering ETN products:
Lyxor pledges collateral for its ETNs
Barclays Capital issues un-collateralised ETNs
ETNs are far more popular in the U.S., where thisstructure has substantial tax advantages wheninvesting in futures-tracking indices
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Commodity ETFs and ETCs
Central clearinghouses and exchanges can be apotential source of counterparty risk in somecommodity ETFs and ETCs
Exchanges are the counterparties to all commoditiesfutures contracts
No major exchange has yet defaulted, and were able
to handle the bankruptcy of major trading bodies likeLehman brothers without any loss of capital
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Trading Disruption: The Real Risk
We have not yet seen any significant loss of investment due to counterparty risk in ETFs, ETCs,or ETNs
However, swap-based funds and ETNs have stoppedtrading or gone into liquidation on multiple occasionsdue to uncertainty
This presents real risks of illiquidity in a market crisis
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ETN Counterparty Risk in Action
September 15, 2008: Lehman Brothers, backingbank for four ETNs on the U.S. market, files for bankruptcy
The only time that exchange-traded products
have seen losses due to counterparty risk These ETNs had seen zero trading volume in the
weeks leading up to Lehman¶s bankruptcy
Only a few million dollars left in each ETN, anamount explainable as seed capital
Investors got their money out, but still needed tofind somewhere new to put it (difficult in the caseof specialty products like the MLP index)
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Trading Disruption: The Real Risk
September 16-22, 2008: ETF Securities line of commodity funds stopped trading on the LondonStock Exchange
First-generation products were only backed bythe credit of AIG (comparable to modern ETNs)
Market makers refused to provide liquidity after the Lehman bankruptcy, trading ceased on the17th
Led to the modern ETC structure, with ringfencedcollateral protecting the investor and marketmakers
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Trading Disruption: The Real Risk
October 19, 2008: Inverse financial sector ETFsstopped trading on the New York Stock Exchange for a few hours
The S.E.C. imposed a ban on short-selling 799financial stocks that morning
The provider could no longer find counterpartieswilling to write short exposure to the U.S.financials sector
Only halted trading for the morning hours, but theETFs remained closed and traded at a premiumfor weeks after
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Trading Disruption: The Real Risk
September 1, 2009: PowerShares liquidated theleveraged long oil ETN backed by Deutsche Bank
The U.S. futures regulator threatened to imposestrict position limits on oil futures, hurtingDeutsche Bank¶s ability to hedge their exposurefrom backing the ETN
Investors were paid out the full NAV of their shares upon liquidation on September 9, butwould need to wait a few more days for payment
Market makers prevented a major discount fromforming as investors sold, because DB still lookedcreditworthy
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