Evercore Pan Asset

The Regulators have rightly been puzzling over what could go wrong from here. They are spoilt for choice, as they seek to distinguish between the risks that can be well managed, and the risks that might in bad circumstances bring the system down again. 
 
The European Regulators are busily stress testing the European banks. They are now aware of the vicious circle that is created when a set of banks which have lent a lot of money to their national government discover that the value of that government debt is falling sharply on the markets.  The regulators do need to ensure that EU banks have enough capital to handle any losses and partial defaults on sovereign debts.
 
The UK Regulators are worrying over Exchange Traded funds and products. They have queried the impact of too many people dealing in ETFs, and wondered if they could get overexposed or if they might short too many. This is but a part of a wider issue. Is there too much programme trading? Do some banks, hedge funds and investors take too much risk, going short of too much or gearing their positions too much? Could this get out of control? This needs to be properly regulated by control of bank balance sheets, and by prudent controls on investment products. 
 
The Regulators have reminded investors that some ETFs put money into a swap, to try to buy close tracking to the index they are trying to reproduce in their performance. Many ETFs try to give you the performance of an underlying index. They might do this simply by buying all the shares in the index in the same proportions as the market. Or they might do it by buying a portfolio of shares, but topping it up with a few percent of their assets in a swap. This swap contract says that if the fund portfolio underperforms the index the bank or other counter party will pay money to the fund. If it outperforms the index the fund will pay money to the bank or other swap partner. 
 
At Evercore Pan Asset we mainly buy ETFs that replicate the index by buying the same shares. If we buy a product with a swap, we like it to be a regulated UCITs fund so we know the swap will be less than 10% of the value. We also like to check that the fund keeps full collateral against the swap, so if anything went wrong with the swap there would still be assets there that the fund can draw on. It is usually possible to invest using a limited risk approach. 
 
The ETF market is now around $1.5 trillion. Whilst big and growing, this is tiny in comparison to all the open positions in futures and options, which amount to an amazing $600 trillion worldwide according to the Bank of International Settlements. Many of these open positions are self cancelling, many have been acquired to reduce risk. These positions also include, however, funds and players who use these sophisticated financial vehicles to gear their bets. It’s fine all the time they are winning, but can prove expensive if they start to go wrong.
 
It is also fine if a company or fund has carefully offset one set of positions with another to balance the risks. If, however, the counter party to one set of transactions gets into difficulties and cannot settle, that can unbalance otherwise prudent and cautious funds, which in turn get into difficulties.
 
I am all in favour of sensible risk reduction through futures and options where appropriate. I do wonder if we need $600 trillion of them, and worry that the business models of some highly geared funds could come unstuck in choppy times. There’s a lot to be said for keeping it simple, and just buying the shares or other assets you want in the proportions you want. If you are going to use a swap there is a strong case for limiting the amount and having some insurance beneath it. If you are using futures and options, it is wise to work out what your full commitment would be if things went seriously wrong, and keep that under sensible control.  Let’s hope the regulators help markets to do just that.

As published in Investment Week