Debbie Fuhr is one of the best-known figures in the exchange-traded fund industry at the global level. Until recently, she was the managing director heading Morgan Stanley's Investment Strategies group, based in London. Her reports on ETFs have been widely read throughout the ETF industry. She parted ways with Morgan Stanley in May, and IndexUniverse.com's European correspondent, Paul Amery, recently caught up with her at the Terrapinn ETF & Indexing Investments conference in London on June 25 for her first interview since leaving her post. Although she was unable to discuss her departure, she did turn her attention to some of the bigggest issues facing ETFs in Europe and abroad, including liquidity, actively managed ETFs and the UCITS III structure.
 

Paul Amery (IU): Debbie, in a recent research report Raimar Dieckmann of Deutsche Bank argued that the European ETF market enjoys a structural advantage over the U.S. market because of UCITS III and the ability of European ETFs to use swaps. Would you agree with this assessment?

Debbie Fuhr (Fuhr): In terms of structuring new products, I think the UCITS framework does add a flexibility that is not available under the 1940 Investment Act in the U.S. But I think that the U.S. does have other advantages, in that there is more of an equity culture on the retail side. And so we have seen retail investors embrace ETFs to a much greater extent than here in Europe. Also, in Europe, the IFA model is a hindrance. Though they are called independent financial advisers, they are not so independent in reality. So both sides of the Atlantic have their pros and cons as far as ETFs are concerned.

IU: What other impact has UCITS III had, as a regulatory framework, on the European ETF market?

Fuhr: I think there are a number of things worth mentioning. First, the ability of funds to use ETFs was capped at 5% of assets under the previous version of UCITS. Under UCITS III, a fund can now invest up to 20% in any one other UCITS fund and up to 100% in total, as long as the funds meet certain regulatory criteria. So UCITS has opened up new opportunities for people to use ETFs, as well as offered more flexibility on the structuring side when designing new products, which you referred to in your first question.

Also, UCITS allows you to go synthetically long and short. This is an area that a lot of firms are looking at. This has been like opening up a Pandora's box for some asset managers; particularly those who are used to the long-only world and who have not been using derivatives. The challenge for some investment managers in using swaps-which, by their nature, are OTC and do not have ISINs or SEDOLs-is that their middle and back offices find it harder to track and account for these instruments. As a result, we see that a lot of asset management firms are stopping short of getting involved with swaps and are sticking with using futures, certificates and ETFs.

IU: Talk of swaps brings us to the topic of counterparty risk, something that has been of increasing concern to investors with the ongoing problems in the credit market. How would you evaluate the choice between ETFs and ETCs/ETNs with their note-type structure? And should swap-based ETFs be a concern to investors, when compared with ETFs holding the underlying securities in specie?

Fuhr: When comparing an ETF to an ETC note or certificate (which are effectively the same thing), clearly you have specific counterparty exposure when holding the latter. For some investors this has been a concern. For example, I've seen some pension plans in Europe decide that they no longer wanted to hold any certificates or notes based upon concern about counterparty issues. From a regulatory perspective, there may well be constraints anyway for some fund managers, limiting holdings in notes to 10% of assets.

As far as what is inside an ETF is concerned, you do find that some investors prefer ETFs that buy shares, as opposed to holding swaps. Also, I think that some people don't realize that there are ETFs that do one or both of these things and don't understand the differences, since they assume that funds simply buy shares. So it really comes down to the knowledge base of the investor and how the product is being positioned, marketed and sold by whomever is doing that. While some people prefer their ETFs not to have swaps, others see the benefits of having reduced or no tracking error from using swaps. So, there are pros and cons in both methods of ETF construction.

IU: One question that has been raised more than once at the conference has been the issue of relatively high bid/offer spreads quoted on European exchanges for ETFs; particularly in retail dealing sizes, and of low secondary market trading activity on the exchanges. We've also heard from the product providers that secondary market liquidity is much better than screen quotes might suggest. Do you think that there is a problem here and, if so, what can be done about increasing the visibility of the underlying trading?

Fuhr: The underlying trading isn't really the issue, as ETFs are as liquid as the basket of shares that they hold. It really comes down to trading with brokers that are able to do the creation/redemption process. In Europe, a lot of the trading activity does not have to be reported to the exchange. So the on-screen liquidity that you see may only reflect 50% or so of the real activity. There is a challenge in that market-makers may quote a tight bid/offer spread for an institution, but not for a small retail investor. The spreads that are shown on-screen are dictated by the exchanges which will typically set requirements that market-makers keep bids and offers within a certain percentage range for a minimum period of time. As far as infrequent trading activity is concerned, some of the European exchanges will capture a closing mid-price for ETFs that don't trade, and others will not. This [latter] policy can make price movements appear very strange when a fund hasn't traded for two weeks, for example. Having all the exchanges consistently publish closing prices would be helpful for everyone.

IU: Does liquidity vary according to whether the listing is primary or secondary?

Fuhr: Again, the quoted liquidity will depend on the individual exchange's reporting requirements, but at the underlying level it shouldn't vary. You will find that investors move from one exchange listing of an ETF to another for different reasons. To give an example, if one wanted to buy the S&P 500 in U.S. dollars rather than euros, it might be necessary to find another listing of the same ETF. For a European retail investor, the choice is more limited-it's usually just the local exchange in the country concerned.

So generally speaking, ETF liquidity should be no different when traded via the primary listing or via one of the cross-listings. The issue of secondary market liquidity is typically more important for someone who hasn't used ETFs before-they feel more comfortable when they see things trade on-exchange and in some volume. Once people start using ETFs and understand them, they become a bit more indifferent to the reported trading volume. Having said that, there is no doubt that in the U.S., for example, seeing billions of dollars of trades every day in certain ETFs has helped attract more retail investors.

IU: In your presentation this morning you mentioned active ETFs. Could you elaborate on how they work and what's going on with this type of fund?

Fuhr: There has been an effort in the U.S. to engage active fund managers in the ETF market, but up to now, the sticking point has been that they don't want to reveal what they, as stock pickers, are holding. There are two different active ETF models that are being proposed; one by the American Stock Exchange and one by Garry Gastineau, who used to work at the Exchange. The general idea is that I, as an active manager, give my portfolio, on a daily basis, to a black box, which creates a basket of longs and shorts that track my real portfolio closely, but where no one can tear it apart and figure out what I own and what I've just sold. That would be the creation/redemption portfolio, and it would allow a truly active fund to become an ETF. According to some people, this type of portfolio has been given to the SEC on a confidential basis for approval as an ETF, but it's not clear how far this process has gone.

IU: Which of the two models do you think works better?

Fuhr: I haven't signed the confidentiality agreement to see either model in full detail, so I couldn't comment on that.

IU: But whatever happens, it will happen in the U.S. first?

Fuhr: You have to be slightly careful here, because Europe has had funds that trade intraday and on-exchange for a long time, on Euronext, for example. What Europe doesn't have is an indicative NAV-the transparency that the typical ETF has. And they don't have an in-kind creation/redemption process. So it depends on how you define an ETF. That's, incidentally, why Euronext calls its ETFs "trackers": to differentiate them from the funds that have been listed on their Amsterdam exchange for 60 years or so.

IU: Which areas are going to be the most popular in the next phase of ETF product development?

Fuhr: In the Middle East, people have been working hard to bring new products to market, so we will see a number of listings on exchanges in that region later this year. Others are actively involved in finding other asset classes that can be offered in an ETF format-hedge fund replication is an area that comes to mind. Many people are looking at low-cost beta and how to gain exposure to multiple asset classes. As people embrace ETFs, they typically then call up and ask, "Is there an ETF on market X?"

Now that we have 90 or so firms that have launched ETFs, they are all looking at ways of doing something new and different. In the States, people are looking at 130/30 strategies as an ETF, for example. And, as well as new products, there's also more to come in terms of the way people are using ETFs; for example, as underlyings for structured products or as part of funds of funds.

And the range of users of ETFs is continuing to grow. Over the last year I've been everywhere from Latin America to Australia, and I've recently come across ETF users in Kazakhstan, China and Saudi Arabia. It's a big change from when I started in the sector 11 years ago, when it was hard to find anybody who'd buy an ETF.