ANY industry would be proud of an average annual growth rate of 34% over ten years and of a global reach from Austria to Taiwan. But the headlong expansion of exchange-traded funds (ETFs), which by May this year controlled almost $1.5 trillion of assets (not far short of the $2 trillion in hedge funds), has become a matter for concern among financial regulators. Could ETFs be the next source of financial scandal, or even of systemic risk?
ETFs have been around since 1990, when the first fund was launched in Canada. The original idea was to create portfolios of shares replicating a stockmarket index, such as the S&P 500. Index-tracking funds had been available to institutional investors since the 1970s. Companies such as Vanguard offered them to individuals in the form of mutual funds. However, as the name suggests, the key feature of an ETF was that it was itself listed on a stockmarket, so that investors could buy and sell it easily. Unlike units in a conventional mutual fund, ETFs can be traded all day long.
Most people still regard these plain-vanilla ETFs as a benign invention that allows small investors to own a diversified portfolio at a low cost. State Street’s $88 billion SPDR fund, which mimics the S&P 500, has a total expense ratio of just 0.09%.
But fund managers quickly elaborated on the basic design. The number of ETFs has swelled to 2,747 (see chart 1). Within equities, there are ETFs based on small-cap companies, value shares, individual industries and every conceivable combination of countries and regions. In bonds, there are ETFs linked to government, corporate and high-yield debt and paper of varying maturities. Some ETFs are based on commodity indices and property markets, others are designed to appeal to the environmentally conscious or to devout Muslims. There are leveraged ETFs which offer a geared return on a given index, inverse ETFs which aim to go down when a benchmark goes up (and vice versa) and, inevitably, leveraged inverse ETFs.
For some, this is a worrying trend, with echoes of the subprime housing crisis, in which financial innovation went out of control. That crisis, too, had its origins in invention with a benign aim: the packaging of mortgages for use as securities for bonds was intended to reduce borrowing costs and disperse risk. Eventually, however, that simple idea transmuted into complex collateralised debt obligations and lower lending standards.
Exotic traded funds
Similarly, the new types of ETF no longer offer the cheapness and diversification of the early varieties. Instead they have become a means for hedge funds to speculate on the market throughout the trading day, allowing them to make complex bets on illiquid asset classes. And the portfolios of some ETFs consist not of a broad range of stocks but of a derivative position with an investment bank as a counterparty.
Official concern is growing. In April three international bodies set out their worries. The Financial Stability Board (FSB), a committee of financial supervisors, issued a report on ETFs. The IMF devoted part of its global financial-stability report to them. And the Bank for International Settlements (BIS) published a paper entitled “Market Structures and Systemic Risks of Exchange-Traded Funds”.
One risk is a lack of liquidity.On May 6th 2010 trading in the American stockmarket seemed to go haywire: the Dow Jones Industrial Average fell by almost 1,000 points in the session and some stocks lost almost all their value. This “flash crash” prompted the authorities to cancel a bunch of trades made at unusual prices. Between 60% and 70% of those trades were in ETFs, far above their actual weighting in the market.
Some investors use ETFs as a quick way of expressing their overall view on the market, while high-frequency traders use the funds as part of their complex arbitrage strategies. But such strategies work only as long as there is someone willing to take the other side of the trade. In chaotic conditions, there may be sellers but no buyers. As the IMF points out, “While most ETFs are supported by one or two marketmakers, there is no guarantee of active trading under illiquid conditions.”
A linked problem is the tendency for ETFs to be the main way in which investors seek exposure to some asset classes, notably gold. Once upon a time gold bulls had to pay a hefty markup to buy coins or had to purchase shares in gold-mining companies and hope that the management was competent. But gold ETFs have been hugely popular, seeing inflows of $12 billion in 2009 and $9 billion in 2010. The largest gold ETF holds more bullion than all the world’s central banks except those of America, France, Germany and Italy. The IMF also has more. The surge of interest in gold ETFs has been encouraged by (and may have in turn contributed to) a rise in the bullion price. If investors lose faith, the market may become disorderly as they scramble to take their profits.
Some ETF managers also top up their income with fees for lending the securities in their portfolios. There is a risk that, in a period of market disruption when ETF investors want their money back, managers would be forced to recall such loans, adding to liquidity pressures.
Another problem lies in the existence of leveraged ETFs, where losses as well as profits can be magnified. Were a leveraged ETF to suffer huge losses, the reputation of the entire industry might be affected, particularly among private investors. Inverse ETFs offer a way for investors to bet on a fall in an asset class but they may not always deliver such a return over an extended period. “It isn’t hard to give examples in which investors would lose money on a leveraged long ETF if the market went up over a period of significant volatility, or in which they lost money owning a short ETF and the market went down over a period in which there were some sharp rallies,” says Terry Smith, chief executive of Tullett Prebon, a money broker.
Perhaps the biggest concern, and the one with the clearest echoes of the subprime crisis, surrounds “synthetic” ETFs and linked products known as exchange-traded notes (ETNs) and exchange-traded vehicles (ETVs). An ETN is a debt security issued by an index provider or a bank and traded on the market; an ETV is similar, but the debt issuer is a special-purpose vehicle. Collectively these offshoots are known as exchange-traded products (ETPs).
The rationale for concocting this alphabet soup is the desire to create funds linked to illiquid asset classes. It may be too costly or impractical to replicate the targeted index completely. To synthesise it, the ETF provider usually enters into a transaction known as a total return swap with a bank. The bank agrees to pay the provider an amount equal to the return on the chosen benchmark, say an emerging-markets index; the provider hands over cash in return. The bank now has to manage the risk of replicating the index; the provider faces the risk that the bank might go bust. So the ETF provider requires the bank to provide collateral (see diagram).
The financial laboratory revisited
Here’s the rub. The collateral is usually unconnected with the index. The BIS cites the example of an emerging-markets ETF offered by a firm called db x-trackers.The collateral was in the form of equities and bonds. Most of it had nothing to do with emerging markets. Around half of the equity portion was in Japanese shares; another 30% consisted of American and German ones. Of the bonds, three-quarters were American, many of them unrated. Were the bank counterparty to fail, the index provider would be left with assets that were unrelated to the target portfolio.
Worse, the BIS points to a potential conflict of interest when the fund provider is owned by an investment bank. When a bank acts as a marketmaker, it needs to keep an inventory of bonds and stocks so that it can deal with clients’ demands to buy and sell. These positions have to be funded, which can be costly, especially if the securities are illiquid. “By transferring these stocks and bonds as collateral assets to the ETF provider sponsored by the parent bank, the investment banking activities may benefit from reduced warehousing costs for these assets,” the BIS warns.
That raises the danger that an ETF could act as a dumping ground for the unwanted securities on an investment bank’s books. “The synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed,” says the FSB report. Again, there are parallels with the subprime crisis, where mortgage-backed securities were warehoused in off-balance-sheet ventures.
If doubts emerged about the health of the bank involved in the swap, investors might be inclined to sell their holdings in the ETF or the ETN rather than take their chances on the exact value of the collateral. After all, as the crisis of 2008 showed, when banks are collapsing the value of all kinds of assets takes a battering.
The structure of synthetic ETFs is not a secret. Anyone who reads the documentation carefully should be aware of the nature of a fund and the type of collateral. It is also worth noting that in America these concerns apply only to ETNs and ETVs. In products labelled as ETFs, at least 80% of the portfolio must comprise securities matching the fund’s name.
In Europe synthetic funds make up around half of the ETF sector by assets. However, the European Fund and Asset Management Association, a trade body, points out that the vast majority of them trade under the UCITS (Undertakings for Collective Investments in Transferable Securities) rules, which limit some of the risks outlined by the BIS and the FSB. For example, rules on conflicts of interest restrict the choice of counterparties, a fund cannot have an exposure to any one counterparty that comprises more than 10% of its value, and the chosen collateral is subject to liquidity and credit-quality criteria.
Nevertheless, the rapid trading of ETFs is an area of concern, especially when the underlying assets are illiquid. Creating a synthetic ETF does not eliminate this illiquidity risk, but merely transforms it into a bet on the creditworthiness of a bank. One day that bet will go wrong.
Despite some eerie parallels, it is hard to conclude that ETFs yet pose a systemic risk on the same scale as mortgage-backed securities. Leveraged funds have around $40 billion of assets, less than 3% of the industry total, according to BlackRock, a fund-management group that, under its iShares brand, is the biggest provider of ETFs. Synthetic ETFs had more than $140 billion of assets in May. Though ETPs have been growing rapidly (see chart 2), their total value is less than $200 billion, less than one-seventh of that of conventional ETFs. It seems unlikely that banks have the same kind of exposure to collapsing ETFs as they did to the subprime market.
Even some in the industry are nervous about the profusion of new vehicles. A failure might diminish the appeal of ETFs as a whole. “There are products that are not even funds which are being called ETFs,” reports Deborah Fuhr of BlackRock. “The risk of confusion, disappointment and disillusionment among investors would be very negative for the ETF industry.”
That would be a shame. Fund managers’ fees have always eaten into investors returns; ETFs were a splendid way of letting investors keep more of their money. But like a hyperactive child, the finance sector can never leave a good thing be.
Hedge funds including SAC Capital Advisor LP and Ortus Capital Management Ltd. are expanding in Hong Kong, fueling demand for space and driving rents higher in the world’s most expensive office market.
SAC Capital of Stamford, Connecticut is in talks to boost its space by 20 percent after adding employees at its more than 5,000-square-foot office at York House, said two people with knowledge of the matter, who declined to be identified because the information isn’t public. Ortus Capital, a $2.5 billion macro hedge fund based in Hong Kong, this month moved into premises 20 percent bigger in St. George’s Building, said a person with knowledge of the matter.
Prime office rents in Central business district rose 8.5 percent from January to the end of May as financial services companies boosted hiring in the city, according to Jones Lang LaSalle Inc.Hong Kong and Singapore are luring global hedge funds returning to the region following their retreat during the 2008 credit crisis.
“Hedge funds and private equity are capable of paying higher rents and they make decisions fast,” said Bernard Chu, director at Sagarmatha Capital Ltd., a Hong Kong-based real estate broker specializing in hedge funds and private equity firms. In Central, “they’re willing to pay around 5 to 10 percent more compared with investment banks, law firms and accounting firms, and they’re willing to pay an even higher premium for grade A buildings such as the International Finance Centre.”
Record Fund Inflow
The $3.6 billion capital that investors added to Asian hedge funds in the first three months was the largest quarterly inflow into the regional industry, according to Chicago-based service provider Hedge Fund Research Inc. The number of hedge funds focused on Asia increased to 1,055 in the first quarter, the highest since the second quarter of 2008.
Nine Masts Capital Ltd., led by Wang Bing, former Asia head of Deutsche Bank AG’s Saba proprietary trading desk, is negotiating to more than double its 1,500-square-foot office space after its assets under management surged 10-fold to more than $300 million since it started trading in May 2010, two people with knowledge of the matter said.
Matchpoint Investment Management Asia Ltd., a Hong Kong- based hedge fund co-founded byOch-Ziff Capital Management Group LLC (OZM) partner Raaj Shah, and Sean Debow, former Asia managing director of Los Angeles-based Ivory Investment Management LP, found a new location where it doubled its space, according to a person with knowledge of the matter.
More Space
The 4,300-square-foot L. Place office it moved into last month provided more room after its staff tripled to more than 15 since its September 2009 inception, and its assets under management jumped fivefold to $270 million, the person said.
Instead of moving, Senrigan Capital Group Ltd., the $1 billion Hong Kong-based hedge fund backed by Blackstone Group LP (BX) and led by former Citadel Investment Group LLC manager Nick Taylor, took an adjacent unit at Wheelock House after it more than doubled its workforce to at least 20 people since it started trading in November 2009, said a person with knowledge of the matter.
Janice Tang, Ortus’s spokeswoman; Katarina Bendle, who represents Senrigan; Elaine Davis, Nine Masts’ chief operating officer; Jonathan Gasthalter, an outside spokesman for SAC Capital, and Matchpoint’s Debow declined to comment.
About 25 of the biggest global hedge fund firms are seeking to expand in Asia, according to a Credit Suisse Group AG report last year. About 75 percent of the top 100 global hedge funds, ranked by Alpha Magazine based on assets managed, will likely have a presence in Asia, according to the Zurich-based bank’s prime brokerage unit.
Actively Looking
“If someone’s still seeking office space in Central at this moment, they’re likely someone who’s willing to pay a very high rent,” said John Siu, Hong Kong-based general manager at Cushman & Wakefield Inc., the biggest closely held property services company. “Hedge funds have been very actively looking for additional space since the market recovered from the credit crisis and it looks like this trend is continuing.”
Hong Kong’s prime office rents jumped more than a third to $2,066.35 per square meter at the end of last year, the highest in the world and almost double the cost of the City of London, according to Colliers International Research.
Average rents for new tenants at top-tier buildings including Cheung Kong Center andInternational Finance Centre in Central stood at HK$159 a square foot per month at the end of May, according to Jones Lang LaSalle. Only 1.3 percent of these buildings are vacant, compared with the 3.7 percent average for the rest of Central, the Chicago-based property brokerage said.
Less Bargaining Power
Hedge funds and asset managers may also be paying more for leases because they usually take up space of between “a few thousand to under 10,000 square feet,” Siu said. That gives them less bargaining power compared with investment banks that take up multiple floors at premium buildings with areas up to “tens of thousands of square feet,” he said.
Central’s higher rents drove some banks and professional services providers such as law and accounting firms out of the district to less expensive areas. Allianz Global, the investment unit of Allianz SE, Europe’s largest insurer, which occupied about 20,500 square feet in Cheung Kong Center, last month moved to nearby Citibank Plaza, where average rents are about 30 percent lower. Deutsche Bank AG last year completed its relocation to the International Commerce Centre in West Kowloon.
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Nancy Davis, a rising star at Goldman Sachs Group Inc., left in January 2008 after an eight-year run betting the firm’s money on derivatives to become a portfolio manager at Highbridge Capital Management LLC. She lost her job 10 months later when the hedge fund cut back in the recession.
For women in the financial-services industry like Davis, who’s still unemployed, the last few years haven’t been kind. More than five times as many women as men lost their jobs in the three years after July 2007, and pay for full-time female managers compared with their male counterparts worsened between 2000 and 2007, according to U.S. government data.
Women managers in finance, a group that includes bank tellers as well as executives, earned 63.9 cents for every dollar of income men earned in 2000, based on median salaries, according to Government Accountability Office statistics analyzed by Bloomberg. In 2007, the last year for which data is available, the figure was 58.8 cents. The 41-cent gap was the biggest in any of 13 industries surveyed by the GAO, and only two others had a widening disparity.
“When you have an industry dominated by men like finance, and compensation going through the roof, it’s not surprising that it increases the gender disparity between men and women,” said Joan C. Williams, a professor at the University of California’s Hastings College of Law in San Francisco who has written on gender and the workplace. “The sky’s the limit for men who hit a home run, but women can’t get to first base.”
Goldman Sachs Lawsuit
It has been more than a decade since a case brought by Smith Barney brokerage employees served to dismantle Wall Street’s mandatory arbitration rules, Merrill Lynch & Co. was confronted with sex-discrimination claims from 900 women and Allison Schieffelin, a former bond saleswoman, filed a gender- bias suit against Morgan Stanley -- a case later settled for $54 million. Yet not a lot has improved for women in banking.
Last month New York-based Goldman Sachs was sued by three former female employees who say they faced discrimination in pay and fewer opportunities for promotion than men at the firm. One of the women claimed she had been pinned against a wall and groped by a male colleague after a 1997 outing that included a stop at Scores, a Manhattan topless bar.
Ed Canaday, a spokesman for Goldman Sachs in New York, said the suit is “without merit” and that the company takes “extraordinary efforts to recruit, develop and retain outstanding women professionals.”
‘Culture Hasn’t Changed’
“Despite their sustained participation and economic influence, women have experienced a shockingly slow rate of progress advancing into business leadership, regardless of industry,” Ilene H. Lang, president and chief executive officer of Catalyst, a New York organization that promotes workplace diversity, told lawmakers at a Sept. 28 hearing in Washington.
It’s harder for women on Wall Street where trading floors can create a hostile environment, said Nina Godiwalla, a former investment banker at Morgan Stanley and author of “Suits: A Woman on Wall Street,” which will be published by Atlas & Co. in February.
“Based on the women I’ve talked to, the culture hasn’t changed,” Godiwalla said. Women are routinely subjected to crude jokes and excluded from outings, she said. “Even if it doesn’t happen to you, you see it around all the time, and it’s just a reminder that you’re not part of the team,” she said.
Maternity ‘Buddy’
To be sure, women have gained some ground over the last decade. Executives including Mary Erdoes, CEO of asset management at JPMorgan Chase & Co., Lisa Carnoy, co-head of global capital markets at Bank of America Corp., and Isabelle Ealet, global head of commodities at Goldman Sachs, have risen to positions of prominence at the biggest U.S. banks.
Davis, 33, said Goldman Sachs and Highbridge, which is owned by JPMorgan, bent “over backward to keep women.”
Goldman gave Davis a maternity “buddy,” a senior female manager, to help her transition back to work after both of her pregnancies and placed her in its Leadership Acceleration Initiative, a program to promote the development of high- performers, she said.
“Of course you’re going to run into your share of jerks on Wall Street, but my experiences at Highbridge and Goldman were very positive,” Davis said. “I was fortunate to work with good groups of people, and I never saw unfairness or discrimination.”
‘Mommy Track’
Still, for a trader with her credentials, finding a job has been harder than she expected. Davis, who ran proprietary derivatives trading for Goldman Sachs, wants something that will allow her to see her 4-year-old and 7-year-old before bed without being relegated to the “mommy track,” she said.
“I interviewed for a job recently with a small hedge fund. I think they were concerned about my ability to work until 2 a.m. given my family commitments,” Davis said. “They realized that, and I realized that. It wasn’t the right fit.”
More than half of women between 15 and 44 years old have children, according to the U.S. Census Bureau, which can cause problems like the ones facing Davis, said Williams. Studies have found that mothers are less likely to be hired or promoted and receive lower pay for similar jobs, Williams said. Becoming a mother is one of the leading reasons women leave Wall Street, she said.
“They get the sense that it’s going to be impossible to have children and keep their jobs at the same time,” Williams said.
Job Losses
The number of women in finance, banking and insurance in the U.S. fell by 537,000 between the second quarter of 2007 and the second quarter of this year, according to data compiled by the Bureau of Labor Statistics. That’s 12.5 percent of women in those industries compared with 3.6 percent of jobs held by males cut in the same period, according to the data. Across all industries, the female workforce decreased by about 2.6 percent, or 1.7 million jobs, in the three-year period, the data shows.
Women who get a foot in the door on Wall Street often find themselves assigned to less prestigious trading desks and divisions with smaller bonus pools, said Kelly Dermody, a partner at Lieff Cabraser Heimann & Bernstein LLP in San Francisco who’s representing the women suing Goldman Sachs along with Outten & Golden LLP. The two law firms have gender- discrimination cases pending against Bank of America and its Merrill Lynch unit, among other firms, Dermody said.
“Women are fighting the same old battles, just in a new environment higher up the chain,” she said. “These cases keep coming and coming. Wall Street isn’t learning the lessons.”
Bloomberg LP, the parent company of Bloomberg News, is currently in litigation with the Equal Employment Opportunity Commission in a gender-discrimination case.
JPMorgan, Citigroup
One of the complaints in the Goldman Sachs case is that the proportion of female managers shrinks at higher levels. Women constituted 29 percent of the firm’s vice presidents, 17 percent of managing directors and 14 percent of partners in 2009, according to the complaint. Four of 30 members of the management committee and one of nine executive officers were women.
JPMorgan has three women on its 16-person operating committee, including Erdoes, Heidi Miller, president of international operations, and Chief Investment Officer Ina Drew. Morgan Stanley has just one woman, Chief Financial Officer Ruth Porat, among its top dozen executives. Citigroup Inc. CEO Vikram Pandit doesn’t have any women on his executive committee, which consists of 19 men, including himself.
Shannon Bell, a spokeswoman for Citigroup, said women run many businesses and important functions, including the firm’s private bank, personal banking and wealth management. Darin Oduyoye, a spokesman for JPMorgan, and Mark Lake, a spokesman for Morgan Stanley, declined to comment.
Unconscious Discrimination
“In the old days, the problem was conscious, explicit discrimination -- the doors were literally closed and we had to put our heads against them and pound them in,” said Susan Estrich, a professor of gender-discrimination law at the University of Southern California in Los Angeles and author of “Sex and Power.”
Discrimination today is largely unconscious, and people in power don’t even realize they’re doing it, she said.
“People who are doing the judging unconsciously prefer people they’re comfortable with, people they know, people who look like them, people whose experience they recognize,” Estrich said.
Sharon Meers, a former managing director at Goldman Sachs who left the firm four years ago to write “Getting to 50/50: How Working Couples Can Have It All by Sharing It All (Random House, 2009),” describes studies in her book that show both men and women are more apt to choose male job candidates over females, even if their credentials are identical.
“The air we breathe is filled with assumptions about men and women that are hard to shake,” Meers said. “Instantaneously and subconsciously, we end up prioritizing men over women in a way that doesn’t make any sense.”
Testosterone’s Role
That’s especially true on Wall Street trading floors, said Williams, the Hastings law professor, who has studied traders.
“The gender bias faced by female traders is open, dramatic and pervasive compared with other professionals,” she said. “It’s all about masculine signaling -- mine’s bigger than yours. But in this case, it’s measured by salary and fueled by risk.”
That may have something to do with testosterone, according to John Coates, a former derivatives trader at Deutsche Bank AG and now a senior research fellow in neuroscience and finance at the University of Cambridge. Coates left the bank to study the correlation between hormones and trading after noticing that male traders exhibited manic behavior during bull markets.
‘Feeds on Itself’
“You put on a trade, you get it right, you make a big win, your testosterone levels go up, you get more confident, you want more risk and this thing feeds on itself,” said Coates, whose studies of traders in London found that men with higher levels of testosterone earned more money. “If you get into a bull market, all these guys are in synch. And eventually they get T levels that are so high they’ve gone over the top of this dose- response curve, and they are over-confident and are putting on too much risk, and it’s risk with terrible risk-reward tradeoffs, and that is a bubble.”
Women produce about 10 percent of the testosterone of an average man in his 20s, which may explain some differences in risk-taking, Coates said. In the investment banks he studied, only 2 percent to 3 percent of the traders were women, while about 60 percent of the asset managers, who have more time to analyze the risks they’re taking, were female. Brokerage accounts managed by women tended to outperform those held by men, he said.
“Women are better at more reflective types of trading or trading that requires more analysis and a longer holding period,” Coates said. “Why isn’t Wall Street valuing that?”
Competition, Risk-Taking
Hormones alone don’t explain the differences between males and females on Wall Street, said Anna Dreber, a researcher at the Institute for Financial Research in Stockholm who’s studying competition and risk-taking among men and women. She said she has found that girls can be as competitive as boys, depending on the environment.
“Even if you have some specific version of a gene that makes it more likely to take a risk, your social environment can still affect whether that gene is expressed or not,” Dreber said. “I would expect a fairly big chunk of the variation of behavior in individuals is some sort of interplay between biological and social variables.”
Davis, who thrived on one of Goldman Sachs’s most elite trading desks, may be an exception to the rule, said Williams, whose latest book is titled “Reshaping the Work-Family Debate: Why Men and Class Matter” (Harvard University Press, 2010).
Walking a Tightrope
Bias against women in the workplace today is more subtle than in the past, she said. Women have to walk a tightrope in the office between being too feminine and not being taken seriously or being too masculine and viewed as a “bitch” with a personality problem, she said. They also have to keep proving their competency, she said.
“There are dramatic gender pressures on both men and women who are traders that systematically disadvantage women, regardless of which hormone is surging when,” Williams said. “The gender pressures on men are to be the biggest cowboy with the biggest gun who shoots the fastest. It’s all about who demonstrates manliness the best.”
