ETFs – a liquid proposition

Michael John Lytle, managing director and founding partner at Source, talks to Emma Cusworth about the importance of increasing liquidity in the European ETF market

Liquidity is a key focus for Source, an exchange-traded product provider born 18 months ago from a coalition of Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley. Other leading names have since joined the platform, including UniCredit, Commerzbank and Nomura, while assets have rocketed to $8bn.

To increase liquidity, Source concentrates listing its products on three exchanges, comprising the Deutsche Boerse, London Stock Exchange and Swiss SIX Exchange. This focus helps to avoid fragmentation of market making and encourages greater trading within the high-velocity hedge fund sector.

Daily on-exchange turnover of ETFs in Europe is roughly $3bn, or 1% of total assets under management (AUM), whereas in the US volumes often exceed $70bn, representing 8%-10% of AUM.

Retail investors, who constitute around 10% of the European ETF market, conduct the majority of trading on-exchange. Institutions prefer over-the-counter (OTC) trading, where greater liquidity can absorb sizeable trades.

“In the US, hedge funds are extremely important to ETF trading volumes,” Lytle explains. “Before summer 2009, no hedge funds were trading ETFs on-exchange in Europe as they weren’t liquid enough.”

The ability to borrow is crucial for hedge funds. They represent around 30% of US daily trading, where there are ample funds available to borrow and a strong create-to-lend market.

“People often think ETFs are as liquid as the underlying shares,” Lytle says. “In fact, that is only implied liquidity. The real measure of liquidity is the daily trading volume. It is much harder to short using ETFs in Europe than the US, which directly impacts trading velocity.”

Sector success

As well as offering a create-to-lend programme so hedge funds can buy and redeem as many shares in an ETF as required, Source launched sector ETFs with enhanced liquidity in July 2009.

Source worked with Stoxx to create the Dow Jones Stoxx 600 Optimised Supersector indices, the first to adjust constituents based on the ability to borrow and liquidity.

Total turnover for Source’s European sector ETFs reached €9.4bn in October, capturing 86% of the total European sector ETF turnover reported in Cascade, Clearstream’s German settlement system. Trading volumes in competing sector ETFs remained stable at €1.5bn.

Prior to Source launching its sector products, volumes were around €1.6-€1.8bn on average.

Now total volumes have been boosted to well over €8bn, peaking at nearly €11bn in October.

Increased liquidity also reduces costs. Source’s Bank ETF tends to trade around 10 basis points wide, well inside both competitor ETFs and futures.

“By increasing liquidity, we have converted some large institutional investors out of OTC swap positions on European sectors,” Lytle says. “Tighter spreads and higher turnover created the opportunity to use ETFs as trading tools, not just to buy-and-hold. We ultimately want more of the long side as that is where we earn fees.

“However, we need hedge fund trading to make ETFs more attractive.” He adds: “We don’t get paid for trading volume, but it is very important for the overall market.”

Hedge fund exposure

Before the financial crisis many investors underestimated the illiquidity risk in hedge funds.

Unable to extricate themselves as performance plummeted because of lock-ins and other gates, many investors were forced to sell more liquid, better-performing assets.

“There is a lot of interest in gaining broad hedge fund exposure,” says Lytle. “Most investors would probably buy fund-of-funds, but they are still only as liquid as the underlying funds.”

Source’s hedge fund ETFs, launched in September, are based on the Merrill Lynch Factor Model index. This uses a rules-based, discretion-free model to take long or short positions in portfolios of highly liquid indices, such as the S&P 500 TR.

Correlation with the HFRI Fund Weighted Composite index exceeds 90% since inception of the ML Factor index in 2003. So far, the funds have attracted $25m.

“Assets are generally flat for the first few months as investors carry out due diligence on the Source platform and products,” Lytle explains. “We have seen broad interest from multi-asset class managers, private banks and small institutions who realised the huge impact of imperfect due diligence in the wake of Madoff.”

Source has also developed products designed to improve access to new asset classes, allowing a broader range of strategies. In June it launched the first volatility-linked ETF in Europe, which tracks the S&P 500 VIX Short-Term Futures index.

The index’s high negative correlation to the S&P 500 allows investors to insure themselves against implied volatility, previously only possible through futures contracts or structured notes.

“It is important to understand, however, that this ETF is not a good buy-and-hold investment. Unlike equities, it does not gain value over time,” Lytle warns.

“It is mean-reverting so investors pay a rolling premium, but if they sell after volatility spikes, they get a chunky return. Realising this profit is crucial to their success as an effective volatility hedge.”

This product is therefore only appropriate for big investors who can understand, implement and actively manage exposure.

“In Europe, ETFs are mainly held by a small collection of large investors, who have this capability,” Lytle says. “To realise the expectations of the European ETF market we have to work with the largest, most sophisticated investors to change the market dynamics. The benefits trickle down so everyone gains.

“Ultimately, this is not a zero-sum game,” Lytle concludes. “There is huge potential for significant asset growth, which benefits all providers. Investors will also get better products, which give more accurate investment returns, perform against expectations and deliver objectives. As a result exchange-traded assets will grow faster than mutual funds.”