10 Jun 2011, Credit Suisse , Asia Risk
Credit Suisse was among the earliest participants in the European exchange-traded fund (ETF) industry with its first fund launched under the XMTCH branding in Switzerland in 2001. A decision to expand its global reach in 2010 has proven timely, with the rebranding of XMTCH to Credit Suisse ETFs (CS ETFs) and the launch of a new Ucits-compliant Dublin platform. Heeding feedback and opinions from investors who were reeling from a major financial crisis allowed Credit Suisse to build a new generation of ETFs that met client expectations using the latest risk management technologies.
Joseph Ho, who recently joined Credit Suisse to head up its ETFs business in Asia-Pacific, explains that the new range of CS ETFs is designed to optimise the balance between performance and risk. “Investors have every right to expect an ETF to track its benchmark closely,” says Ho. “And we employ whichever replication methodology – physical or synthetic – to achieve that objective.” Physical ETFs hold the corresponding underlying benchmark constituents directly, while synthetic ETFs derive their benchmark performances using swaps or other derivatives purchased from a third party, such as investment banks.
Pros and cons
The replication methodology of ETFs has been a hot debate since the collapse of Lehman Brothers and the ensuing concerns over counterparty risk. Almost all ETFs domiciled in the US are physically replicated, whereas roughly half of the ETFs from Europe are synthetic.
“Both methodologies have their advantages and disadvantages,” Ho explains. “Historically, the choice of replication methodology among issuers has not been due to risk considerations, but more to do with the regulatory requirements and tax considerations of the domicile of the ETFs, and the indexing capability of the issuer,” he says. In Hong Kong, the split between physical and synthetic ETFs is about half and half.
On the surface, physical replication is easier to understand, with no apparent counterparty risk. However, physical ETFs can take on counterparty risks when they conduct stock lending activities. In addition, physical ETFs are prone to higher tracking errors when tracking complex benchmarks and in restrictive markets. On the contrary, synthetic ETFs are more efficient and cost-effective, but their use of derivatives can unnerve investors with counterparty concerns.
“At Credit Suisse, we are able to leverage our experienced internal indexing team for physical replication, as well as our strong investment banking business for synthetic replication,” Ho explains. “That allows us the flexibility of using the appropriate replication methodology to ensure tight tracking for all CS ETFs.”
Ho admits that some investors, even institutional ones, feel uncomfortable with synthetic ETFs. He attributes that partly to a lack of understanding towards these products and partly to the legacy concerns over derivatives after the Lehman bankruptcy. “A swap-based ETF is not a derivative; many investors still get it wrong,” Ho adds. “Also, the net counterparty exposure of swap-based ETFs is often limited to 10% of net asset value (NAV) under most mutual fund regulations.” He says not all synthetic ETFs are created equal, and investors should look carefully at the individual fund’s structure and the risk control measures in place to minimise counterparty risk.
Ho points out that all swap-based CS ETFs are fully collateralised and the collateral baskets are marked-to-market on a daily basis. Credit Suisse also commits to using only constituents from the Euro Stoxx 600 index universe as collateral. Any discrepancy between the value of a CS ETF and its collateral basket is made whole at the end of every day, minimising potential loss to intra-day. Information on the collateral baskets is available daily on the CS ETF website, further enhancing transparency. “The risk control mechanism we built for our synthetic ETF is absolutely state of the art,” Ho says. “BNY Mellon, which is the independent trustee of our Dublin range of ETFs, holds the collateral baskets directly and is in a position to liquidate these baskets and return cash to investors if there is a counterparty failure.”
Ho urges investors to take a more balanced view when investing in ETFs. He explains that, in the current heated debate, the performance risk or tracking error has been brushed aside too easily while the counterparty risk has been over-emphasised. While this risk-averse sentiment is understandable, Ho suggests that institutional investors who are in a stronger position to monitor and control counterparty risks could be more discernible when selecting ETF products.
In fact, Ho says, the largest and most-traded ETF in Hong Kong has been a synthetic ETF tracking the China A-shares markets, despite all the misgivings of synthetic replication. “Investors are capable of making their own judgements,” he concludes.
Global access and trading
Ho believes the immediate focus for CS ETFs in Asia would be to target regional institutional investors who are not confined to trading locally and want accessibility to a full range of products that is not available due to market fragmentation and high maintenance costs. In addition, the misconception of a lack of on-screen volume for regional listed ETFs has driven many investors – mostly institutional ones – to trade outside of the region.
The ability to provide Asian clients with competitive pricing within Asian time zones, regardless of where the ETFs are trading, will be key to Credit Suisse’s success, Ho says.
“Given our strong focus on institutional clients, we have put in place a process whereby investors can speak to our market-makers to agree on pricing in the Asian time zones, and have the ETF trade executed in Europe,” Ho explains.
To ensure liquidity, Credit Suisse, among others, has been appointed as market-maker for CS ETFs listed across the different European markets. Investors can expect Credit Suisse and other market-makers to quote real-time two-way prices that are close to the intra-day NAVs during market hours, regardless of the prevailing trading volume.
Investment trends change fast in Asia, and that is why ETFs are proving useful. In 2009, emerging markets were all the rage. Market sentiment then shifted to developed markets from mid-2010. Recently, attention again returned to the emerging countries, Ho says. He also mentions that other themes being sought out by investors lately include gold, commodities and alternative energy, in response to the recent earthquake in Japan.
The next level
An effective channel to distribute ETFs has always been a hard case to crack, as ETFs generally do not offer upfront commissions or rebates to distributors. Unlike traditional mutual funds, ETFs cannot be pushed on investors, but are rather a demand-pull product. This involves a major education and marketing effort on the part of issuers. Given the fragmented markets, Ho says no single issuer can undertake this Herculean task alone.
“By focusing on institutional investors and leveraging on our trading support capability and existing product range, we are committed to bringing innovation, transparency and trust to investors in the Asian market,” Ho says. On potential clients, Ho is quick to point out that, while it is difficult to show statistical support, the number of Asian institutions using ETFs has continued to expand. Private wealth management, as a sector, has shown the most growth after the financial crisis. “It was almost impossible to get a meeting with the private banks before the crisis,” Ho recounts. “Now ETFs are being offered as an alternative to traditional mutual funds, as well as being used as implementation tools in the discretionary cross-asset solutions.”
Ho also notes that Lippo Investment Management was the first asset manager to focus on offering funds of ETFs in Hong Kong, and Lion Fund’s qualified domestic institutional investor (QDII) gold fund emerged as the most successful QDII offering in recent years, having raised close to US$500 million for investments in gold ETFs traded overseas. These are two examples of extended usage by professional investors.
Credit Suisse is working on cross-listing a selective range of ETFs in Asia despite its emphasis on direct selling to institutions. Ho explains that a regional listing will serve to raise the profile of CS ETFs in Asia for long-term development, and will allow Credit Suisse to monitor the growth of the ETF markets in the region. Selective cross-listing will also allow regional asset managers to build feeder fund structures around them, he says. “Thai asset managers have been active in launching foreign investment funds feeding into ETFs trading in the region. Local listing is important for them as they need local closings to price their feeder funds.”
Credit Suisse ETFs profile
The first CS ETF was launched in 2001 under the XMTCH brand. It is the fourth largest ETF provider in Europe and the tenth largest globally. Since rebranding from XMTCH to CS ETFs in early 2010, assets under manage-ment have grown to US$18 billion, representing an 87% increase within the past 17 months. CS ETFs offer three separate ranges domiciled in Switzerland, Luxembourg and Ireland, respectively, and comprise 58 ETFs with most of them trading on five European bourses. Product range includes 42 equity, 13 fixed-income and three commodity ETFs, of which 42 are physically replicated and 16 are synthetically replicated.
The Ucits-compliant Irish range currently includes 46 CS ETFs and will form the backbone of CS ETFs’ future product development
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