ETFs - avoiding the CDO wasteland

Regulators are comparing ETFs with collateralised debt obligations, but do the two products share any common ground? Helen Fowler reports

If regulators were caught napping by the last financial crisis, they look determined to avoid a repeat this time around. Many, however, are barking up the wrong tree in suggesting ETFs could serve as a transmission mechanism in the same way collateralised debt obligations once did.

ETF providers point out that, beyond sharing three-letter acronyms for titles, the two products have little else in common. “It is not even a vaguely sensible comparison,” said Nizam Hamid, head of ETF strategy at Lyxor, Europe’s second largest provider. “There is a world of difference between the two.”

Investors in ETFs also defend the products. “It comes down to a question of collateral,” said Christopher Aldous, chief executive of Evercore Pan-Asset Capital Management, a firm that invests most of its £500m of assets in ETFs. “People are saying they are the same thing. I would disagree, for the principal reason that a CDO is built of lower quality assets that are repackaged, in many cases with gearing involved.”

Indeed, comparing ETFs with CDOs is a superficial move. Aldous said: “A lot of people don’t really understand CDOs, they hear ‘collateral’ and ‘collateralised’, and they don’t understand. Swap-based ETFs are a long way away from CDOs. They will be at least 90% collateralised.”

What are the differences?
Under the CDO structure, issuers would typically take a bundle of assets, borrow against those assets, then package together assets and borrowings. The next step was to persuade a ratings agency to give the product, or at least parts of it, a triple-A rating. Investors flocked to buy the securities because, although the product was typically triple-A rated, it offered a slightly higher yield than anything available elsewhere.

In contrast, a standard ETF structure does not involve borrowing, although investors should be careful to check what they are buying, since exchange-traded notes, products and commodities rely on non-fund structures.

Around two-thirds of Europe’s €260bn ETF industry uses derivatives, bought over-the-counter, to track their indices. But they do so in a more regulated way than any CDO ever did, before that industry disappeared around three years ago, when investors finally became aware of their dangers.

“I would characterise the comparison as unnecessary and sensationalist,” said Ben Johnson, director of European ETF research at Morningstar. “Both products have three-letter acronyms, both have experienced rapid growth, or, rather, the CDO market did while it was around, and each of them represents a stake in a portfolio of financial assets. That is where the similarities begin – and end.”