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Comparing Like With Like
Written by Paul Amery   
May 26, 2011

Terry Smith’s broadside against ETFs from earlier this week, echoed today by Jonathan Guthrie, City editor at The Financial Times, has now been met by a counterattack. Alan Miller, former equity fund manager and now owner of SCM private, a wealth management firm, challenges Smith head-on in an opinion piece in The Daily Telegraph.

Smith highlights counterparty and collateral risks in ETFs as a major concern, then goes on to claim that the combination of short selling and exchange-traded funds may be creating little-understood structural risks, which could in turn lead to a repeat of last year’s flash crash.

Not so, argues Miller. By comparison with the disclosure levels offered by the average active manager, says Miller, ETFs are a paragon of openness. “Fundsmith (Smith’s active fund vehicle) shows the list of its top 10 holdings by name (but without percentage held) on a monthly basis,” says Miller. “According to the Fundsmith website, it holds 23 stocks within the fund, of which it reveals just 10. [By contrast] most ETFs show every single holding in full, and with percentages, daily.”

And when it comes to the risks incurred by high levels of short selling via ETFs, continues Miller, these pale into insignificance when compared with the sometimes highly illiquid stocks held by active funds.

“Most large ETFs follow large liquid indices, such as the FTSE 100 or S&P 500,” says Miller, “so there are no liquidity issues with these funds being very large indeed. In fact, the action of the market makers and hedge funds using ETFs as an efficient, liquid hedge against their exposures increases the trading volume of ETFs, thereby reducing their spread and therefore cost to investors.”

“In fact the danger is much greater in several of the largest popular UK mutual funds, Miller goes on. “One £1 billion-plus UK fund, for example, has holdings in several small-/mid-size UK companies where, together with other internal funds, they hold nearly 30 percent of the equity. What would happen if this high profile manager were to be run over by the proverbial Clapham omnibus and investors all decided to sell?”

So who’s right—Smith or Miller?

Let’s start with counterparty and collateral risks. These undoubtedly exist in ETFs—whether swap-based or physically backed. But the same risks are present in many actively managed funds too, and usually with levels of disclosure that are far lower than those offered by ETF providers.

In Fidelity’s investment funds simplified prospectus (taking one of the largest mutual fund operators in the UK as an example) it’s clearly stated that “for funds that use derivative transactions, there is a risk that the counterparty to the transaction will wholly or partially fail to honour its contractual obligations. This may result in financial loss to the fund”.  Fidelity’s website doesn’t disclose to whom derivative exposures are incurred on behalf of fundholders, how counterparty risk exposures are managed and what collateral is provided to back derivative contracts used by the manager’s funds. The average ETF issuer discloses all these things (although some are more open than others when it comes to the frequency and quality of collateral disclosure).

And active fund managers lend out securities just as ETFs do. ETFs and index funds lend out more stock, on average, than actively managed funds (since their holdings are more stable over time, making them a more reliable source of stock for the borrower), but the same questions of collateral management and counterparty risks apply in active funds as they do in their passive cousins. Whose disclosure is better? Again, almost certainly ETFs', though it’s not great for either type of fund when securities lending is involved.



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