EDHEC-Risk Institute has just released a position paper entitled “What are the risks of European ETFs?” Could you tell us about some of the principal conclusions of this study?

Noël Amenc: First of all, we feel that the debate on the risks of ETFs to date has not been based on a coherent theoretical framework and that the views of competing interests have not been conducive to sound regulation in the area.

For example, the vast majority of European ETFs are managed within the UCITS framework and as such have the same levels of security and the same risks as any UCITS fund. Highlighting the supposed risks of ETFs therefore makes little sense, and even less so in matters of retail investor protection in that ETFs represent but a fraction of the products sold to the general public in Europe and competing investment vehicles typically do not benefit from the same level of protection as that provided by the UCITS framework.

As far as counterparty risk is concerned, we think that it makes little sense to oppose physical replication and synthetic replication products on the one hand, or draw a fine line between unfunded and funded swaps on the other. Both distinctions are largely irrelevant in practice and convey a false sense of "comparative" safety. In fact, whatever the replication techniques employed, ETFs are exposed to counterparty risk.

The issue of counterparty risk should be addressed through clear guidelines on counterparty risk mitigation up to the quality, marketability and diversification of assets performing the economic role of collateral and these should apply irrespective of the manner in which counterparty risk is assumed or mitigated, and to all UCITS and competing investment vehicles.

Transparency should not be restricted to the problems posed by counterparty risk and its mitigation, but should include disclosure of the revenues and costs from ancillary activities such as securities lending.

Finally, while most ETFs are passive investment vehicles tracking indices, there is no standardisation or mandatory information on tracking error risk today in the European regulations.

With ESMA’s consultation paper on ETF regulation due to be released shortly, what are some of the conclusions that the regulator could draw from your research?

Noël Amenc: The academic literature has underlined the importance of taking the right regulatory approach to minimise the risk of adverse selection, and more broadly of free-rider problems, which lead investors to place trust in rules that falsely appear to protect them. We consider that to optimise its intervention, the regulator should ensure that the rules it sets are parsimonious and effective.

With respect to parsimony, we consider it key that the regulator avoids creating categories or condoning communication that would be based on of portfolio management techniques rather than economic differences; such distinctions would promote a false sense of protection.

For the sake of avoiding ambiguity and erroneous risk assessments, such transparency rules should apply horizontally, that is, to all investment products, whether UCITS or not, marketed in Europe rather than to UCITS ETFs only.

The regulator should also be aware that its publicised concerns, information requests, and consultations are also a message sent to investors. By directing their thoughts and attention to the regulatory improvement of counterparty risk mitigation in ETFs or the possible systemic implications of the OTC derivatives and securities lending transactions of ETFs, we believe regulators have overlooked a first-order issue i.e. the comparability of performance amongst ETFs. First, we consider it key that investors be provided with information on the total return generated through the risks assumed on their behalf by funds, including the monetary benefits of securities lending operations. Second, we regard as essential that indexing vehicles be required to disclose tracking error targets and results. While index funds have grown on the back of passive management, there is no standardised measure or mandated disclosure of the quality of index replication at the European level.

In the same spirit, we consider that it is critical that regulators give a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes, which after all remain the main drivers of the financial risks assumed by ETFs.

The position paper is critical of the marketing and media relations campaigns implemented by some ETF providers in an effort to promote counterparty-risk based distinctions between physical and synthetic replication ETFs? Could you expand on this?

Noël Amenc: Yes, in any competitive field, it is fair practice to try and convince clients of the superiority of one’s products. As far as savings and investment products go, superiority cannot be assessed solely by considering raw performance as risk must be taken into account. Since 2007, investors have become increasingly sensitive to risk considerations when making investment decisions. Today’s perception of fund risks goes beyond the purely financial risk-return aspects and encompasses operational issues in a broad sense, notably the risk of default by a counterparty relied upon to implement the fund’s policy and generate its risk-return profile.

Against this backdrop, a number of providers looking to strengthen their competitive edge on the fast-growing and profitable ETF market have “informed” investors and regulators of the counterparty risk arising from the use of OTC derivatives by funds implementing synthetic replication. The same have emphasised the distinction between unfunded and funded swaps suggesting that the latter offered better protection against counterparty risk.

However, any UCITS can take on more unmitigated counterparty risk through securities lending than via OTC derivatives and physical replication ETFs, unlike their synthetic counterparts, routinely engage in securities lending. Also, UCITS limit counterparty risk from all OTC derivatives transactions; the distinction between funded and unfunded swaps does not exist in the UCITS Directives but arises from the interpretation of CESR guidelines. Since those require transposition by each individual country, distinctions between funded and unfunded swaps need to be based on a country-by-country analysis.

These false distinctions may lead investors to pay less attention to first order issues that determine the effective mitigation of counterparty risk: the quality of the assets performing the economic role of collateral and the ability of the fund to enforce its rights against collateral in the case of default by the counterparty.

Interestingly on these two counts, there is little in the way of European guidelines governing the taking of collateral to mitigate the risk from securities lending and specialists recommend the use of robust standard master agreements to deal with the legal risks arising from the activity.

About Noël Amenc

Noël Amenc is professor of finance and director of development at EDHEC Business School, where he heads the EDHEC-Risk Institute. He is also chairman of EDHEC-Risk Indices & Benchmarks. He has a masters degree in economics and a PhD in finance and has conducted active research in the fields of quantitative equity management, portfolio performance analysis, and active asset allocation, resulting in numerous academic and practitioner articles and books.

He is a member of the editorial board of the Journal of Portfolio Management, associate editor of the Journal of Alternative Investments, member of the advisory board of the Journal of Index Investing and a member of the scientific advisory council of the AMF (French financial regulatory authority).