Active ETFs carry real market making risks, say experts
Active exchange traded funds (ETFs) face a tough battle to win investor approval if financial regulators in other parts of Asia Pacific follow Australia’s lead to halt listings of the hybrid products.
Fund industry players across the region are weighing in on the debate about active ETFs after the Australian Securities and Investments Commission said it would not allow further listings while it conducts a review of the appropriate regulatory regime for the funds.
Unlike traditional ETFs, an active ETF does not track an index. Instead, it seeks to invest in a portfolio of securities to reach stated investment objectives. The idea is to mix the cheap operating costs of traditional ETFs with the potential to outperform benchmark indexes.
The active ETF market is growing strongly in Australia, in part because Australian insurers and superannuation funds use the products as one means to invest into factor-based equity strategies. These so-called active quant and smart beta strategies help them diversify away from traditional asset approaches, or give them new options to try and match their investments more closely against long-term return targets.
Morningstar reported that over 30 active ETFs are now listed on the Australian Securities Exchange (ASX) and many more are in the pipeline. Their combined market capitalisation is believed to be around $1.8 billion. And a recent Vanguard Australia survey shows that self-managed super funds are increasingly using ETFs to diversify their portfolios.
Until its latest announcement, Asic had broadly been accommodating in how it oversaw active ETFs. The watchdog had introduced special disclosure rules that ensured funds did not have to make their full portfolio holdings public on a daily basis – something the managers argued was necessary to avoid competitors getting access to their key portfolio data.
Asic’s change of mind took place on Tuesday (July 30), when it published a notice to the industry on 30 July asking all stock exchanges in Australia to "cease admitting non-transparent investment products with internal market markers for the time being”.
An internal market maker works as part of the fund promoter's market mechanism, rather than being independent of it and setting pricing according to regular market competition.
The regulator noted that active ETFs only have to publish an indicative net asset value NAV during live trading and the portfolio composition is kept hidden except for the internal market maker. It said it believes this information dissymmetry may be open to abuse.
ACTIVE ETF SCEPTICISM
The caution of the regulator was applauded by several market experts, who pointed to active ETFs’ potentially larger risk, lower liquidity than regular ETF products and the risks they raise by deliberately attempting to avoid transparency about their market positions.
Tobias Bland, chief executive of ETF manager Enhanced Investment Products (EIP) in Hong Kong, shares some of the regulator’s scepticism. He told AsianInvestor that there were several reasons why concept of internal market makers does not seem to be logical.
“You are limited to a single counterparty who is “inside” [the fund manager that created the ETF],” he noted. “The risk is that a single counterparty may not have the ability to maintain a tight market, given their exclusivity.”
He added that stock exchanges need to come up with an incentive to ensure multiple market makers, as this competition that will favour a better level of service for investors.
Active ETFs "try to provide the advantages of true ETFs but without the transparency,” added Stewart Aldcroft, managing director of Cititrust in Hong Kong. “I remain sceptical about them until much greater analysis has been done, directly comparing them with mutual funds and true index based ETFs.”
Bland suggested the ASX and other exchanges should ask active ETF fund managers to have a redemption mechanism at the close of the next day's NAV. This would effectively offer investors in the ETF a firm price instead of an indicative one. “This means investors are protected,” said.
Andrew McCabe, the head of beta products at EIP, agreed that ASIC was right to request a pause, as there are valid concerns over active ETFs and having internal market makers is “a crazy concept”.
“One must ask why they were not addressed prior to launch,” McCabe added.
"I worked as an ETF market maker for several years at Deutsche, and there were always eyebrows raised when people realised there was a relationship between us and DWS (the issuers of X-Tracker ETFs),” McCabe added. “Even if there wasn’t an explicit conflict of interest, it just looks bad.”
Asic did not respond to requests for comment on its decision to delay further active ETF listings. But in its statement, the regulator said it is also concerned about potential conflicts of interest arising if fund managers include profits made from internal market making activities in the active ETFs’ performance fee calculation.
This, Asic said, could “increase the incentive for the internal market maker to widen the spreads to generate a higher performance fee".
RESOLVING CONFLICTS
While concerns over active ETFs exist, the market experts said they were resolvable. Regarding internal market makers, McCabe noted there that “there is no reason why several independent market makers can’t be ‘wall-crossed’ and bound by confidentiality agreements with active issuers.
“I always noticed as a market maker that if there was ever any issue with my data feeds and therefore my pricing, I would always be found out very quickly if there were other market makers for that product,” he added.
Active ETFs are only available in three Asia Pacific markets – Hong Kong, Australia and South Korea. However, the rules differ in each market. While some regulators require full portfolio disclosure to the public on a daily basis (for example, Korea), Australia permits the provision of active ETF portfolio information to participating dealers and market makers ahead of the public.
Hong Kong’s Securities and Futures Commission (SFC) has had its own reservations about active ETF transparency. It stated in its review of the territory’s local ETF market in 2018 that “since the emergence of active ETFs in the US in 2008, portfolio transparency of active ETFs has been under much debate”.
However, the regulator said it gained feedback from other markets and the fund industry feedback that demanding that active ETFs’ daily disclose their full portfolios to the public would hinder the growth of active ETFs. It stated that its current regulatory practice “has been running smoothly and so far we are not aware of any major issues”.
CHART: AUSTRALIAN ETP ASSETS
Source: Morningstar