Evercore Pan Asset

This week the Financial Stability Board published a short paper about Exchange Traded Funds. They were right to do so. Now there are $1.5 trillion of these funds around the world it is important that the authorities supervise them actively and ensure orderly conduct.
 
The Board was broadly favourable. It praises the way ETFs offer flexibility and cost efficiency to investors, and offers a solution to tracking an index. These are the features that has brought us to use them. The Board also draws attention to the way financial innovation is adding to the list of “plain vanilla” ETFs that buy shares to track indices a range of more sophisticated products with more than could go wrong.
 
We have long called for a different name to be used for the more complex ETFs. We ourselves do not buy ETFs which have more active management and risk built in. We do not buy funds which go short or gear. Stock markets are risky enough in our view, without increasing the bet by these means. If an ETF departs from simply buying all the shares of the index in the right proportions and holding them, we examine what other features are deployed to try to get better index tracking. 
 
Some limited use of synthetic products can work. An ETF manager can buy a portfolio of shares, and then have a contract with a bank or other counter party in the form of a promise by that counter party to make up any difference in performance between the share portfolio and the index. In return the ETF manager agrees to pay away any surplus. If this contract is with a secure and reputable bank and is a small proportion of the total assets of the fund it can be a useful way of cutting index tracking error. We agree with the FSB that we need high standards of transparency so we as advisers can see what the arrangements are and satisfy ourselves that they are sensible.
 
The FSB also raises the issue of stock lending. ETFs may well lend out their shares to other market participants to earn an additional income. This can offset some of the inevitable costs in ETFs, to help get the fund nearer to perfect tracking. We think this is usually a sensible risk to run, as stock lending is protected by rules and requirements so the fund doing the lending is not normally at risk. The FSB needs to ensure that stock lending generally in the market is and remains under good regulatory control. 
 
We devote time and money to researching ETFs. It is now an umbrella term. The simple ETFs are just portfolios of shares that nearly match an underlying index. Not all the more complex activities are wrong or even very risky. In moderation they allow better tracking. There are now, however, some ETFs that are considerably riskier. These need to be understood by both investors and regulators. Transparency is the best protection, once such funds have been permitted. The Regulators also need to ensure that each fund does have a proper structure of governance and good custodian arrangements so the assets remain for the owners if we ever return to very stressed market conditions with major banks in trouble. No ETF went down in the Credit Crunch collapse, which was an encouraging sign at a time when people lost large sums of money in collapsing banks and in many other assets. ETF holders of course did lose in line with market movements where they held ETFs tracking risky markets, but did not see their funds collapse in the way some hedge funds did.