If it does what it says on the tin, does it matter what's inside? ETF providers argue it doesn't, but regulators beg to differ.

[This blog first appeared on our sister site, IndexUniverse.eu]

I’ve often heard ETF issuers say that as long as their fund does what it’s supposed to do and tracks its index, who cares how it’s put together? Investors should consider their ETF as a car or a mobile phone, issuers suggest, and value a fund for its utility, not its engineering.

This assertion, however, ignores two key problems.

First, someone in search of a new phone still needs to choose between the tens of thousands of different deals on offer.

Do you want pay-as-you-go, a 12-, 24- or 36- month contract or a SIM-only deal? Would you prefer your iPhone 4 with 8, 16 or 32 gigabytes of memory, do you want to pay more for the “S” at the end, how many “free” minutes of calling do you need, and how much internet access do you want to get charged for in addition?

At this point I suspect that 99 percent of us give up. And, unfortunately, there are no easy-to-understand comparisons available to guide us on our way by reducing product comparisons to simple, like-for-like measures.

Of course, if there are several competing providers of services, you might assume that the cost of any contract is going to bear some resemblance to its real worth. So perhaps it’s not necessary to spend too much time tearing your hair out worrying about comparability. You may not arrive at the absolute best deal, but you should be thereabouts.

But is that a fair assumption? One mobile phone operator may undercut competitors, but if you sign up with the company you may discover that its network coverage is poor, you can’t get a signal at home and you’ve just locked yourself into a three-year contract.

The Bank of England suggested this summer that the lower-than-average total expense ratios charged by European synthetic ETFs, when compared with those levied by funds using physical replication, might reflect synergies between bank-owned asset managers and their parent banks’ trading desks. But those lower charges could also disguise inbuilt risks that are not being fully understood by investors, the UK’s central bank theorised.

To give another example, iShares recently told the market that to collateralise its Hong Kong-based FTSE A50 China Index ETF would cost 50-100 basis points on top of the fund’s existing total expense ratio of 1.39 percent, taking costs to over 2 percent a year. But Deutsche Bank, via its Singapore-listed CSI 300 Index ETF, is offering collateralised exposure to Chinese A shares (albeit via a different index), for 50 basis points, a quarter of the cost of the iShares fund.

Why the difference? Is db x-trackers subsidising its fees for this particular fund to attract assets from the iShares ETF, the largest tracker fund in the region? Is the bank making up the gap in fees via securities lending, trading, or a difference in the way it provides collateral backing? If iShares is really being charged 100 basis points by third parties for collateralised exposure to A shares, why doesn’t Deutsche Bank sell its quota to iShares, rather than to its in-house ETF? These are all fair questions to ask. On the basis of publicly available information, it’s impossible to answer them.

This brings us to the second problem, which also goes to the heart of the financial crisis.

During last Friday’s stimulating debate at the Centre for European Policy Studies in Brussels on the ETF market and UCITS, one issuer made the standard comparison between ETFs and cars, and argued that if your investment vehicle gets you where you want to go, do you really need to worry about how its engine works?

The regulators at the CEPS event responded that the simple act of driving a car imposes direct costs (in economists’ jargon, “negative externalities”) on others: both on other drivers (by adding to congestion) and on the general public (via pollution). Public policymakers therefore need to step in and set some ground rules, regulators concluded, surely indisputably.

It’s not difficult to see how the financial industry has externalised its own costs, leaving taxpayers to pick up the bill for the aftermath of the credit bubble (and the bills for several bailouts over previous decades, too).

Unfortunately, global financial regulators seem to be heading in precisely the wrong direction, enshrining “too big to fail” status at so-called “systemically important financial institutions” (albeit with higher capital standards for those on the list) rather than charting a path towards the total removal of government support for banks.

At Friday’s ETF-focused debate in Brussels, it was clear that regulators were particularly concerned about the possible risks arising from synthetic ETFs precisely because many of the banks issuing them have such systemic importance. Those among the bank-backed ETF issuers who complain that they are not being treated equally with issuers of physically backed funds, typically asset management firms (for example in the assessment of collateral exposures), surely have to accept this point.

But systemic risk contagion could arise from the asset management sector, too. Take the US$2.6 trillion US money market fund (MMF) business, where the promise of a minimum US$1 per share redemption value, enshrined by convention and hinted at in marketing literature, is in fact not a guarantee at all. Meanwhile, maintaining a stable NAV under conditions of near-zero interest rates is becoming tougher and tougher.

As Robert Dubois has ably described on IndexUniverse.eu, there’s still limited transparency into how exactly these funds operate. While the US government stepped in and guaranteed money market fund NAVs at US$1 in 2008, there’s presumably less likelihood that it would be able to do so in our current, straitened times. But even though it seems like an obvious solution just to tell investors that they may not receive a minimum US$1 per share back for their MMF holdings, the US SEC is still reluctant to accept the need for a fully floating (i.e. market-driven) NAV for these funds. Why? The regulators are panicked at the prospect of a run on MMFs.

How all these competing forces can be reconciled and whether regulators can ever arrive at a level playing field is debatable. On Friday in Brussels, the talk was of undertaking a broader review of the UCITS rules and a deeper examination of shadow banking—repo market, money market funds, securities lending and all. All this smacks of a discussion that could extend several years into the future. That’s good news for regulators, lawyers and journalists like me, who will get to report on it. But not, I suspect, for consumers of financial products, nor for the world economy.

Whether markets will wait that long (and not force government and bank defaults long before) is a very good question.

Meanwhile, as if they didn’t have other things to worry about, investors now need to keep an ear open for complex regulatory discussions when selecting a financial product and product provider. Getting from A to B sounds simple, but travellers may face unexpected risks, unmapped detours and a sudden imposition of tolls along the road.

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