EY hosted their annual ETF Roadshow conferences last week in Dublin, London, and Luxembourg. Given the popularity of ETFs across the global asset management industry, the sessions were “standing room only.” I was fortunate to be a panelist in both Dublin and London. Here are my some of my highlights.
1. ETF Industry Welcomes Regulatory Spotlight
Overall industry sentiment around the Central Bank of Ireland’s (CBI) exchange traded fund (ETF) work to date has been positive. September’s feedback statement recognizes the CBI’s obligation as the regulator of the EU’s largest ETF domicile and their recent thorough review has allowed them to proactively engage, contribute, and influence forthcoming international discussions on ETFs. The CBI’s work also does not operate in a vacuum; it co-exists with the ongoing work of ESMA, IOSCO, and the US Securities and Exchange Commission (SEC) who are also putting a spotlight on ETF themes and risk areas.
2. ETF Share Class Innovations
The CBI’s Catharine Dwyer reconfirmed that the CBI will permit products that have listed and un-listed share classes in the same fund. This opens the possibility of adding mutual fund share classes to new or existing ETFs. Many attendees we spoke to suggested it is most likely that the market will see sponsors set up new ETFs and add institutional share classes of mutual funds to those ETFs.
The industry had advocated to allow approval of ETF share classes on existing mutual funds. However, the CBI’s stance is to refer to the existing ESMA requirement that requires UCITS ETFs to explicitly reference ETF in their title and not at share class level. This method also creates significant difficulties for fund sponsors and boards who would need to contact existing shareholders and advise them of the change to their existing fund to an ETF (even if it is in name only). That obstacle might hinder the success of the strategy.
3. Portfolio Transparency Debate
Global regulators, including the CBI, continue to ponder the proper degree of portfolio transparency in ETFs and continue to seek further engagement with stakeholders. The industry is pushing for approval of non-transparent or semi-transparent ETFs to provide a boost to the small but growing area of actively managed ETFs. Transparency to the entire market, transparency limited to authorized participants, or no transparency are all options currently in play within the debate.
Many ETF managers believe that the requirement to publish portfolio holdings daily continues to hinder the growth of active ETF strategies. Others believe there is no “secret sauce” in most active strategies that require such anonymity.
To date the SEC, ESMA, and the CBI have not yet approved the sale of non-transparent ETFs. However, Australia recently allowed such funds and saw growth in the market. It seems the ETF portfolio transparency debate will continue to rumble on into 2019 and is likely to be concluded or at least advanced at IOSCO level in order to facilitate global harmonization to the greatest extent.
4. Brexit and ETF Settlements
Brexit has introduced complications for ETFs domiciled in Ireland. Tara O’Reilly, Partner at Arthur Cox, described the impact to ETF settlement currently conducted for Irish listed funds at CREST in the UK. CREST, a UK-based firm who has settled Irish trades since the ‘90s, ceases to become an authorized settler under the EU Central Securities Depositary Regulation (CSDR) post Brexit. CREST may apply for recognition under third country equivalence but given the chicken and egg situation of either being in EU or not it cannot apply for such recognition until after the UK leaves the EU. Such equivalence decisions normally take six months to conclude. The ETF marketplace cannot afford a six-month gap between Brexit and an equivalency decision on CREST, so the question remains: what do we do in the interim?
O’Reilly believes despite all the current industry debate around workable solutions which include options such as establishment of a brand new Irish CSD (Ireland is currently the only EU member without its own central securities depository) or utilization of the International CSD (ICSD) model, the immediate solution is simpler and within Ireland’s powers to resolve. CSDR allows national discretions to EU member states like Ireland to recognize third country depositaries as equivalent. The European Commission has also recently suggested a more immediate temporary third country equivalence recognition of CREST to prevent the cliff edge impact. Industry participants domiciled in Ireland are currently seeking confirmation from the CBI and Irish Department of Finance that the continued link of Irish securities to the UK depositary will continue to exist and if that’s the preferred interim solution.
5. More ETF Market Entrants Expected in EU
Several asset managers mentioned new UCITS ETF launches and a strong suggestion that given the size and maturity of the EU that there remained a considerable amount of capacity remaining for new ETF entrants. Panelists also suggested that newer entrants to the ETF market would not likely attempt to compete with the large industry incumbents who employ broad-based indexing strategies, but rather with fresh innovative products focused on very targeted exposures or styles to the market. We expect active ETFs will become a larger part of the EU marketplace mirroring a trend we’ve witnessed in the slightly more mature US.
6. ETF Custodian Operating Models
As with most asset management conferences today, there were the many interesting discussions on technology trends including robot process automation (RPA), artificial intelligence (AI), big data, and deep learning. Several panels focused on using technology to enable the client journey from product design to launch. This requires the use of investor portals to enhance customer experience, strong connectivity to ETF market infrastructure, and global service models staffed with knowledgeable people.
7. Thematic ETFs
There was a feisty but respectful debate between asset managers on both the value and probable success rates of thematic ETFs. A thematic ETF is one which targets investment in an isolated niche of a market. They can be very narrow or broader based depending on the investors risk appetite. One school of thought suggested that thematic is just another name for active management – there is no scientific proof that they outperform, they have transparency constraints which are difficult to manage, they have short-term investment horizons and therefore limited shelf life, and they normally contain concentration risk which makes their risk exposure more like single stock investing. The other side suggested that investors, and more importantly advisors, are demanding thematic portfolio composition to capture evolving areas of the market. It also gives advisors and distributors an understandable and contemporary story to tell clients which helps engagement.
8. Fixed Income ETFs
Institutions are beginning to treat certain ETFs like they are securities. For example, a Vanguard panelist told of how they have already begun using ETFs in the fixed income space for duration and credit calls. If asset managers start using ETFs at scale as eligible trading collateral and within securities financing transactions (for derivatives, securities lending, repos etc.), it is very likely that policymakers will need to look at this area and review reference price sources and default triggers, as bond ETF exposure has different risk characteristics to that of directly held sovereign and corporate bonds. This would be a fundamental change to the capital markets, and regulators are universally sensitive to bond market adjustments, so this is a theme worth keeping on the radar.