Dan Draper, head of ETFs at Credit Suisse, tells Emma Cusworth about the firm's entrance into the UK market with its new generation swap-based products
The latest stage in the evolution of the ETF market is being dubbed the “new generation.” Although providers are adopting this term in slightly different ways, it can be seen to mark the birth of product ranges encompassing both traditional and synthetic replication, with an emphasis on transparency.
Credit Suisse is one of the firms at the forefront of this development. The Swiss bank launched its inaugural UK range of 45 ETFs, including its new swap-based products in September.
The firm’s initial UK offering comprises traditionally replicated funds tracking mainstream indices and 13 swap-based emerging market products. This range includes the first Ucits III, Chinese A-Shares ETF listed in Europe, based on the CSI 300 index.
In pursuit of worldwide ETF growth, Credit Suisse has formed a joint venture between its asset management and investment banking divisions, to benefit from combined capabilities and bypass transaction fees.
Dan Draper, head of ETFs at Credit Suisse, emphasises the firm’s on-going commitment to traditional replication but explains some markets are more suited to swap-based products. “Emerging markets are a great candidate. Liquidity is very limited in many emerging markets so traditional replication relies on an optimised sample of the index or some degree of guesswork, given time and currency differences. Both factors likely increase tracking error and volatility.”
In traditional replication investors bear the risk of higher tracking error, in contrast with synthetic ETFs. Draper says: “For emerging markets, there is an opportunity cost for not using swap-based ETFs, which do not pass on tracking-error risk to the end customer. It transfers to the investment bank providing the swap.”
In return, however, investors are exposed to counterparty risk. Under the joint venture, Credit Suisse Securities, with a Tier 1 capital ratio of 16.3%, as of 30 June 2010, is the sole counterparty for all 13 ETFs.
“Ucits limits counterparty risk to 10%,” Draper says, “but our ETFs also reset daily and are marked-to-market.” While intraday volatility could affect counterparty risk, in traditionally replicated ETFs it increases tracking error risk.
“For our funds, counterparty risk resets to zero at the end of every trading day and clients know the fund resets to 100% of the index value after the market closes, even if things go pear-shaped,” says Draper. “The investors’ basket of assets is also completely transparent, published on our website and composed of blue-chip equities. The return from this basket is ‘swapped’ for the exact return of the ETF’s emerging market index.”
As many ETFs reset weekly or monthly, Draper says Credit Suisse clients benefit from greater transparency. “Less frequent resetting means counterparty risk can linger and fund values can change. You know what you own as a Credit Suisse ETF investor and you know the value of that collateral will equal 100% of the index value you are tracking every day. This is the highest level of transparency and quality in the market.”
According to Credit Suisse research, transparency regarding underlying assets and counterparty risk is paramount for investors considering synthetic versus full replication. “By resetting daily and publishing synthetic ETFs’ holdings on the website, we are introducing a new concept,” Draper says. “This level of transparency is crucial, which is supported by direct client feedback and regulatory trends.”
Many of Credit Suisse’s clients are active, institutional managers. “These guys just want efficient ETFs that work without nasty surprises,” Draper says. “They spend time up-front to ensure they are selecting ETFs with the highest levels of transparency and risk management. Beyond that they want to focus most of their energy and resources generating alpha.”
According to Draper, ETFs also empower retail investors by providing access to portfolio management tools previously only available to institutions. “It is a real development in how people save and plan for their future,” he says. “Much like healthcare, people are now required to become more informed to take advantage of the best options available. Future generations need to be much more financially savvy as the increasing retirement age and decreasing state benefits place more onus on self-directed investment and planning.”
Although retail investors have been slower to adopt ETFs outside the US, regulatory developments look favourable. The UK’s Retail Distribution Review laid the groundwork for a shift towards fee-based rather than commission-driven advice, making inexpensive ETFs attractive.
“Australian and other European regulators are looking in the same direction,” Draper says. “We now need more education for IFAs to develop the necessary portfolio management skills. In effect, as a tool, ETFs have developed faster than the IFA business model.”
For many retail investors, however, the pace of development and increased complexity in the ETF market will set alarm bells ringing. “It is important to remember these are Ucits funds, not structured products or notes,” says Draper. “These are funds with boards of directors, fiduciaries who oversee their running on investors’ behalf. It is important to stress the corporate governance and fiscal advantages of using a Ucits fund over a note.”
Formally combining Credit Suisse’s established strength in fund management and structured finance gives the firm a considerable edge. Draper says: “By forming a 50/50 joint venture we are bringing together the infrastructure and trust of the asset management business with the structuring and liquidity capabilities of the investment bank. Considering the changing evolution of the industry and regulation, the better long-term strategy for ETF growth is to really combine the best capabilities of the entire bank.”
He says ultimately, ETFs are about providing the highest quality and most efficient tools for people of all levels to increase the probability of achieving their long-term financial goals. “This is a very forward-looking part of the industry and Credit Suisse wants to play a leading role.”
Dan joined Credit Suisse in March this year from Lyxor Asset Management, where he was managing director and global head of ETFs. Prior to this, he was the director of UK and Ireland business development at iShares.
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