hidden risks in etfs

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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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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The collateral basket may bear little resemblance tothe fund¶s reference index.



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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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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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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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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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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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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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