ETFs: An Introduction
ETFs are funds that track a stock index, bonds, or commodities. In contrast to mutual funds, exchange-traded funds are not actively managed, since their policy is only to reproduce the same diversification of a particular index.[1]
Passive Investment Strategy
Investors in these open-end funds pursue a passive investment strategy. Banks usually offer two different types of ETFs, which both have the same purpose. One is a physical ETF which holds the same amount and allocation of stocks of the underlying index. The other is a synthetic ETF that tries to replicate with financial instruments the equity market, e.g., S&P 500 through swaps to achieve the same amount of return.[2]
Figure 1 – the Global growth of ETFs – Source: Financial Times (2017)
Figure 1 above portrays the global growth of ETFs from the year 2015 to 2017. Over the last ten years, a steady increase can be noticed. Even Larry Fink, leader of the biggest Investment management corporation and the biggest provider of ETFs, BlackRock, has predicted a rise up to $400bn in the next decade[3]. Due to this very high demand, there is a strong interest on the part of the banks to expand their offer of these kinds of funds
Disadvantages
A difficult matter for banks is to replicate an index as close as possible. It is especially crucial in physical ETFs as weighing of stocks in an index may change. This might be the case when a company issues new equity or a company joins or leaves the index. As a result, the index must be adapted again and again. For large indices, e.g., MSCI World, which consists of more than 1600 shares a 1 to 1 replica is almost impossible.[4]
Financial Institutions tend to buy a comprehensible number of individual stocks to replicate the development of the underlying market. This increases the probability of a tracking error, and the ETF could perform worse than the market index.
Figure 2 - ISHARES CORE S&P 500 UCITS ETF USD – ACC (yellow) - S&P500 Index (blue) - Source: Comdirect Bank (2018)
Figure 2 above illustrates the performance of a physical ETF and the underlying S&P 500 Index. Noticeable is the distinction between the year 2011 and 2015, where the ETF was outperformed by the S&P 500. It is clear proof that banks have difficulties in replicating.
Since most investors require a certain amount of security, there is a hitch with physical hedge missing for synthetic ETFs. In this case, there is counterparty risk. If the latter happens and a bank goes bankrupt, investors might struggle to get their money back. Because of this, most market participants shy away from spending a huge amount of money on such ETFs. For this reason, the bank has to hedge them with derivatives or put assets aside which, however, cause costs. Bank lends these assets to get an additional return. However, they are compounded by another counterparty risk. Due to the high competition among global banks, they tend to reduce the cost of ETFs which results in increased risk.
Advantages of ETFs
ETFs act as a significant profit generator for banks. Research by Deutsche Bank indicates that banks make a collective annual profit of between €600 million and €1 billion from ETF[5]. The management fee or the total expense ratio is the largest source of revenues from ETFs. Banks also generate revenues from inventory management and hedging. The banks that issues ETF hedges the exposure to swap by purchasing the underlying index components in the tracked index and this implies that banks have the ETF on their balance sheet and can use them to generate revenues through activities such as security lending and enhancement of dividend as dictated by the index being tracked[6]. Dividend enhancement allows banks to receive 100% of the dividend. An investment bank having trading operations in multiple countries can hedge against exposure by buying stock from countries where the stock is not subjected to withholding tax such as France. Therefore, the bank receives a 10% dividend.
Fig.3. ETFs closely tracking the return on the underlying assets
Figure 3 illustrates how the ETFs closely monitor the return on the underlying assets.
The synthetic exchange-traded funds can help investment banks to save hundreds of millions of dollars in funding costs. The banks can use cash from ETF investors to finance the illiquid assets that banks are required to hold as part of their market-making function. The investment banks need considerable inventory in the form of loans, bonds, and stock. These inventories have to be funded by short-term commercial paper or through the repo transactions. However, banks can avoid these costs by swapping some of its inventory by the synthetic ETF in return for investors cash[7]. The inventory is kept as collateral by the provider of the ETF can be used to pay investors in the event the investment bank defaults. Research shows that banks could enjoy$200 million annually funding advantage by offloading $20 billion of inventory into the collateral basket of ETF.
Conclusion
ETFs have gained popularity in the banking industry because they are a significant source of revenues and funding for investment banks. However, they have also brought several risks or rather demerits that can have adverse effects on the banking industry. The markets from which ETF assets derive their value might be less liquid since there is over-reliance on the authorized participants. Furthermore, Synthetic ETFs tend to pose collateral and counterparty risks that might trigger funding liquidity risk for investment banks. In that connection, it is proper for the banks to conduct in-depth research into ETFs and make the right decisions that would not affect them in the long run. The inflow of banks into the synthetic ETF is alarming and may pose significant risks in the future. On the other hand, with increasingly rapid changes in the market, it is appropriate for the relevant authorities to monitor its development closely.
Bibliography
"Exchange Traded Funds ETFs Definition From Financial Times Lexicon." Lexicon.Ft.Com, Last modified 2018. http://lexicon.ft.com/Term?term=exchange-traded-funds--ETFs.
"MSCI World Index." Msci.com, Last modified 2018. https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb
"Vanguard - What Are Physical And Synthetic Etfs?". Advisors.Vanguard.Com, Last modified 2018. https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_PhysicalSynthetic.
Dunkley, Emma. "How Banks Make Money From ETFs." Wealth Manager, Last modified 2012. https://citywire.co.uk/wealth-manager/news/how-banks-make-money-from-etfs/a561150.
Flood, Chris. "Synthetic ETFs Help Big Banks Cut Funding Costs | Financial Times." Ft.Com, Last modified 2011. https://www.ft.com/content/072f83cc-0a05-11e1-8d46-00144feabdc0.
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[1] "Vanguard - What Are Physical And Synthetic Etfs?", Advisors.Vanguard.Com, Last modified 2018, https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_PhysicalSyn
[2] "Exchange Traded Funds ETFs Definition From Financial Times Lexicon," Lexicon.Ft.Com, Last modified 2018, http://lexicon.ft.com/Term?term=exchange-traded-funds--ETFs.
[3] Peter Smith, "Blackrock Stakes Claim On ‘Sustainable Investing’ Revolution | Financial Times", Ft.Com, Last modified 2018, https://www.ft.com/content/f66b2a9e-d53d-11e8-a854-33d6f82e62f8.
[4] MSCI World Index (2018). Accessed Nov.9, 2018. URL: https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb.
[5] Emma Dunkley, "How Banks Make Money From ETFs," Wealth Manager, Last modified 2012, https://citywire.co.uk/wealth-manager/news/how-banks-make-money-from-etfs/a561150.
[6] Ibd.
[7] Chris Flood, "Synthetic ETFs Help Big Banks Cut Funding Costs | Financial Times," Ft.Com, Last modified 2011, https://www.ft.com/content/072f83cc-0a05-11e1-8d46-00144feabdc0.
