IFAs still concerned about synthetic ETFs and stock lending, L&G survey shows

Jun 12th, 2012 | By | Category: ETF and Index News

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Research amongst IFAs by Legal & General Investments, the UK’s largest provider of retail index mutual funds, shows that seven in ten (69%) advisers are concerned about the counterparty risks associated with derivative-based, or so-called synthetic, index funds and ETFs.

IFAs still concerned about synthetic ETFs and stock lending, L&G survey shows

"Given the complexity of these arrangements and the underlying risks involved, it is understandable that some advisers are worried," said Simon Ellis, MD of L&G Investments.

The research found that, when asked about the counterparty risks associated with the products, two-fifths (40%) said they were very concerned with an additional 29% expressing that they were slightly concerned. In addition, six in ten advisers (62%) expressed concern over the counterparty risks associated with stock lending programmes.

Commenting on the findings, Simon Ellis, Managing Director of Legal & General Investments, said: “There is a lack of clarity surrounding the counterparty arrangements involved both in derivative-based indexing strategies and stock lending programmes and this is clearly a concern amongst IFAs. Given the complexity of these arrangements and the underlying risks involved, it is understandable that some advisers are worried.”

On synthetic ETFs, Bernie Thurston, Head of Delta One Data, thinks the debate around synthetic vs physical is overly simplistic. He believes replication methods should be taken into account as part of a more holistic approach to assessing all potential risks. Moreover, he highlights some distinct benefits of the synthetic approach: “Some of the advantages synthetic providers have brought to the market include lower overall investment costs, reduced tracking error and access to markets which otherwise cannot be invested in physically.”

Thurston added: “At the same time, they [synthetic ETF providers] have tried to address some of the systemic risks which they may pose through increased transparency and diversification of counterparty risk. All of the main synthetic providers, Lyxor, DBx and CS ETFs publish the substitute basket that they are holding. The CS ETFs have also taken this to a high level of disclosure ensuring that all the synthetic ETFs consist of ‘high quality, liquid, blue chip European securities’. ETF Securities and Source have tried to reduce counterparty risk by ensuring their have credit diversification across a number of participants.”

An example of how this credit risk diversification works is Legal & General’s very own derivative-based ETF, the LGIM Commodity Composite Source ETF (LGCU). LGCU combines a 100% physical investment in US Treasury Bills with a swap overlay to provide exposure to the underlying commodity indices. To mitigate risk, the ETF diversifies counterparty risk by entering into swap agreements with multiple counterparties.  Currently, the four appointed swap counterparties are Barclays Capital, Citigroup, JP Morgan, and UBS.

Many argue that the risks relating to stock lending are also potentially misunderstood or overplayed. Stefan Kaiser, director at Blackrock, the company behind the iShares range of ETFs, said: “There has been an increased focus on counterparty risk, but it’s significantly mitigated by over collateralisation, collateral liquidity and lending to a diversified set of counterparties. Neither BlackRock, or its clients have experienced a loss in securities lending through borrower default since the programme’s inception”, reported Rebecca Hampson in the Financial News.

The findings are based on a survey of 294 IFAs carried out by Legal & General in April 2012.

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