Elizabeth Savage, research director at Rathbones, discusses how the firm uses structured products and the main points to consider when selecting exchange traded funds (ETFs).
What type of beta products do you use and why?
We use structured products and ETFs as smart beta plays. Structured products are a useful way to access beta, while incorporating attractive risk asymmetry.
For example, one can buy a structured product that offers participation in the rise of the FTSE 100 index while preserving capital in the event of a decline in that index.
ETFs are used to invest in highly efficient markets where active managers struggle to outperform – one example is the US equity market. ETFs also offer access to markets that are difficult to invest in directly, owing to structural reasons.
For example, many investors find it impractical and expensive to take physical delivery of a physical commodity, and therefore physically backed ETFs provide a neat solution to such a problem, where storage costs are pooled and economies of scale can be achieved.
ETFs can also be used for tactical purposes when an investor wants to change their asset allocation quickly and at a low cost.
How do you choose the type of beta products to implement your views?
For ETFs, the main consideration is cost efficiency and liquidity. If the ETF is more expensive than an active manager, then it is unlikely to be attractive to us. It might sound like an obvious point, but for beta one products, a low tracking error is very important.
The vehicle must also have a robust structure. In this context, we look at a range of factors such as replication methodology; whether there is a swap counterparty; collateral arrangements; stock-lending policies; and tax treatment, to name a few.
With structured products, we conduct thorough due diligence on the platform, as well as wrapper and counterparty credit risk.
We also determine whether the risk/return profile of a particular product is expected to fulfil our investment objectives, not only at maturity, but throughout its life.
Why can ETFs be seen as efficient vehicles for tapping large markets?
It is important to point out that not all ETFs are efficient vehicles – they would need to display a low tracking error, offer reasonable liquidity and carry a low cost in order to be deemed efficient.
We have seen some ETFs within the fixed income space that are more expensive than active fixed income funds. This to us seems an oxymoron. Naturally, replication is easier and more efficient in larger, more liquid markets, such as large cap equity markets.
Do you have any concerns about using swap-based ETFs, as opposed to physical?
We have a definite preference for physically backed ETFs, where it is logical that an investment solution should have direct exposure to the underlying asset it purports to track – gold being a classic example.
It is more difficult to justify buying a FTSE 100 tracker where the pay-off is delivered through a swap, but the underlying collateral comprises a range of securities across geographies, where performance may be hugely uncorrelated to the index being tracked.
We understand that swap-based ETFs might be more appropriate for situations where it is not possible to physically replicate an index fully due to liquidity constraints, and physically backed ETFs may display higher tracking errors.
When investing in swap-based ETFs, it is important to ensure we have enough transparency to understand the collateral that is backing the swap, as well as the counterparty risk.
What are your views on securities lending undertaken by index trackers?
Stock-lending is an important part of minimising tracking error. It also helps to subsidise fees, thereby reducing headline total expense ratios. Investors must ensure, however, that the stock-lending process is robust, that stock is lent to creditworthy counterparties, and that the rebate achieved through lending is sufficient to justify the risk.
It is also important that investors are given sufficient transparency to make sound judgement calls on these factors. Securities lending is only appropriate for physically backed products; it is not acceptable to lend out the collateral backing swap-based products.