“We look at the equity market within any particular market so they’re built up from country…into regional indices,” he says.
“In Australia’s case we look at all the stocks listed in the Australian market.
“Predominantly, we screen the stocks for liquidity – that’s the major thing we look for. Are we building an investible-type index that managers can purchase securities in and actually replicate or at least get exposure to the securities that are in the index?
“There’s nothing worse than a manager having a stock in an index that it can’t buy because there’s no liquidity in that particular stock.
“If you’re looking at an ETF, you’re effectively looking for a product [where] the index underneath the ETF needs to be very transparent in its methodology, so that’s a huge thing.
“We also build benchmark indices that are looking to offer all the opportunities there are in the market, but also balance that out with the turnover that’s possible of stocks going in and out of an index and trying to manage that as well.
“We build indices that are global and built from the bottom up, style and thematic indices, [and] a lot of market capitalisation indices as well.”
Susan Darroch, head of global equity beta solutions (GEBS) Asia Pacific ex Japan at State Street Global Advisors (SSgA), says when they decided they would offer a new ETF in the marketplace, they also decided it would need to track a custom index that targeted higher than average dividend yield.
“[MSCI] looked at the consistency and persistence of high dividend yield stocks and a few other things that made it the index we ended up choosing,” she says.
“With all of our ETFs, we fully replicate those indexes so we hold it at approximately the same weight as it is in the index except for the small caps one. [With] small caps, we take into account that some of the stocks are less liquid than others so we don’t necessarily hold all of the stocks in that.
“We do a little bit of an optimisation so that we still emulate the characteristics of the underlying index,” Darroch says.
“But we do that with probably about 90 per cent of the stocks held in the index.”
Anderson says the methodology used for the resulting SPDR MSCI Australia Select High Dividend Yield ETF was a global one,“effectively customised for Australia, [taking] into account the Australian marketplace and the influences there”.
Guy Maguire, director and head of index services at Standard & Poor’s, says: “S&P Indices locally and globally is committed to the provision of custom indices and we consider this a core competency supporting ETFs and other product structures.
“The Australian ETF market is still in early stages of development and the extent to which the ETF market will grow, particularly over the next two to three years, will leverage recognised index brands,” he says.
“S&P Indices, including the S&P/ASX index suite denoting the underlying index, clearly support the value proposition of ETF offerings, rather than the absence of a recognised index brand.”
DO SYNTHETIC ETFs FIT IN THE PICTURE?
When the Financial Stability Board, an international regulatory body overseeing the global financial system, released a report raising concerns about counterparty risks brought on by synthetic ETFs, it sparked a frenzy of negativity around ETFs.
In Australia, the reason for the success of ETFs can be narrowed down to their simple and transparent structure – and, in most cases, no exposure to derivatives.
However, as the industry started to grow, “people started tinkering with the original structure”, says Tom Keenan, director of Blackrock’s iShares.
“And that’s what gave birth to the rise of synthetic ETFs.”
The increasing popularity of synthetic structures is evident overseas, mainly Europe, as demonstrated by their high frequency trading. Synthetic ETFs have a market share of about 45 per cent in Europe, compared to 14 per cent of the ETF industry on a global scale.
The synthetic model uses derivatives in order to deliver investment market exposure to investors.
Keenan says the most common way to do this is to use swaps.
“Within that swap structure, there is an ETF provider that uses a swap counterparty, who is in some instances the parent company of the investment bank. So you’ve got these related parties as the counterparty of the swap, and at times, there is no transparency around collateral that’s pledged in that swap,” Keenan says.
He says this in turn begins to compromise the principles at the core of ETFs – namely transparency and simplicity.
However, the majority of ETFs listed on the Australian Securities Exchange (ASX) have no derivative exposure at all – they are simply “plain vanilla” structures.
“We don’t think all synthetic ETFs are bad, but we think there are ways that you can mitigate the inherent risks associated with running swap-based ETFs.
“Out of 51 Australian ETFs, there’s only two that have any sort of swap-based arrangement,” Keenan says.
“I would argue that it’s the best regulated ETF market in the world because…the regulator can look at what’s been generated offshore and recognise some mistakes that have been made [to] make sure those same mistakes don’t get made.
“The regulator must have the ability to look inside those synthetic ETFs and work out what they believe is the best way to deliver [it]; that might be ETFs that have multiple swap counterparties that offer full transparency of the collateral pledged in the swap arrangement.
