- INVESTMENTS&ETFs 24 Feb 2009

INVESTMENTS&ETFs 24 Feb 2009

Written by Wilfred Ling

Tuesday, 24 February 2009

Today I attended the INVESTMENTS&ETFs seminar organized by Terrapinn. It started on Moday (23 Feb) and will end on the 25 Feb (tomorrow). Both speakers and audiences were all from institutions. There was no member of the public. There were about 100 delegates. Some are local institutions while others were flowed from abroad. I met some from a local fund house and another from a Singapore government regulatory board. Also met a friend who just join iShares. I am pleasantly surprised that there were interest from the institutions with regard to indexing and ETFs. Normally such boring investments attract no interest as investors in this part of the world are usually gamblers. And as expected, there were hardly any presence from local FAs [ETFs pay no commission and so this is not a surprise]. Besides Promiseland, there were only another two FA firms present. I pick up some interesting knowledge that I did not know previously such as:

More than 80% of the ETFs traded in Europe are OTC. This means that the actual trading volume on the exchange is not representative of the true turnover. [But those that does OTC are likely institutions.]
The counterparty risk for swap-based ETF is restricted to at most 10% of the NAV. The rest of the 90% is not at risk. To be sure, the context that this statement was made is with regard to Deutsche Bank’s db x-trackers. [When I have the time, I’ll look at the prospectus to confirm]
However, an institution disagreed that the 90% is not at risk. Unfortunately, I did not understand the explanation given.
UCITS III were mentioned many times. One of the advantages of UCITS III is with regard to tax efficiency. It was mentioned briefly that normally an ETF suffer two taxes – tax at source (withholding tax) and tax when dividend is distributed. Apparently the second problem does not exist for UCITS III. There was no further detail on UCITS III mentioned. [I guess I have to research/verify on this in greater detail if I want to know more]
An insight into how a market maker does its job was explained. In a diagram shown, a market maker initially started out like a weighing scale. On the left of the weighing scale is a long position while on the left of the scale is a short position. Short position is achieved through various means such as futures, swaps, short selling. The weighing scale initially is perfectly balanced so that the net position for the market maker is neutral. A market maker is not an investor and hence has no desire to participate in the market risk. When an investor wishes to buy the ETF from the market maker, the market maker’s weighing scale will be tilted to the right resulting in a net short position. To ensure the scale is balanced, the market maker has to cover its short position by buying the equivalent securities of the underlying market. The price of the basket of shares is the price that the market maker will sell to the ETF purchaser. The market maker cannot sell at a very expensive price if (a) The market maker is obligated to quote tight spread (b) Quote symmetrically on each buy/sell. If the market maker quote a selling price that is unreasonable expensive, arbitrage opportunity exists for other market players to earn free risk free money. The lesson I learn is that liquidity is not an issue if (a) The market maker has a contractual obligation to quote a tight spread and (b) quote on both sell/buy.
It was demonstrated what a market maker contractual obligation may look like by giving an example. One market maker was obligated to provide three levels of market making service. Level 1,2 and 3. For Level 1, the maker must quote at given bid-ask spread. Moreover, it must also quote at certain volume at buy/sell order. If Level 1 is used up, Level 2 will be used. Level 2 will have a larger spread and smaller volumn.
Interestingly, the market maker is permitted to quote at a larger spread/smaller volume if the underlying market is not trading. This is because greater risk incurred by the market maker as the underlying securities are not trading. The market maker has to use other forms to hedge is position such as futures and swaps.
Deutsche Bank’s db x-trackers used some sort of enhancement to improve its tracking error and sometime even able to outperform the index. Normally, dividends of an ETF is taxed at maximum rate for foreign investors. However, it was mentioned that db x-trackers is able to improve tax efficiency as the dividends are taxed at local rates if this is possible. [I will have to verify this in the prospectus on another day]
43% of the world’s trading volume in November 2008 was due to ETF.

It was mentioned many times that the liquidity of the ETF is unimportant if there is a market maker. I am unsure whether is this a sales pitch or really true. For me, if I would to recommend such ETFs to my clients and that these ETFs lack liquidity, I would want to see in print the obligation of the appointed market maker such as its qualify of service namely the bid-ask spread, the volume it must quote and the obligation that the quote is symmetrical.

Comments

Add New

RSS