Last month, we examined the IOSCO (International Organisation of Securities Commissions) Consultation Report on ETF Good Practices. This month’s column delves further into Measure 6 of the consultation, which is on conflicts of interest.
Specifically, it is worth examining creation/redemption baskets that are negotiated bilaterally between an authorised participant (AP) and the ETF issuer, also known as custom baskets. The report broaches the possibility that a favourable basket could be created to the detriment of existing shareholders. This article endeavours to address how the set-up and structure of the ETF ecosystem make this implausible.
Concerns about potential conflicts of interest have been raised in the past. These have included discussions surrounding price dislocation in the fixed income space between the ETF and prices of underlying bonds during the period of market stress in 2020 the allegation being that APs and ETF issuers could have strategically included illiquid bonds from their existing fund holdings as part of the custom basket.
The argument goes that APs could in turn become disincentivised to trade the underlying securities, thereby reducing their liquidity and effectively breaking a cog in the arbitrage mechanism which serves to realign the price of an ETF to its net asset value (NAV).
For example, in the instance of an ETF trading at a discount to NAV, an AP is incentivised to buy ETF shares and then proceed to sell the shares at NAV, which would naturally reconverge the two prices.
Digging deeper, the argument is that ETF issuers attempted to construct concentrated baskets when in fact the reality was to the contrary. Amid the issues of price transparency surrounding the volatility of March 2020, a larger and varied basket was the solution to not only minimise tracking error but also satisfy demand from APs and relieve them of the predicament of how to deal with a concentrated portfolio of bonds.
Furthermore, if we take the example of an optimised and index tracking ETF that holds one-third of the index holdings, a skewed custom basket for a sizeable order – representing the aforementioned removal of illiquid securities from the fund – would inevitably create tracking error. This would go against the core principle of an index tracking ETF, which is to track the index, and would damage the reputation of the issuer and the fund in question.
As a key metric upon which investors make their portfolio allocations, if tracking error were to occur, confidence in the issuer’s ability to track the index would be lost and the ripple down effects would begin to have a material effect, with reputation risk at stake.
From the AP's perspective, owing to their utilisation of ETFs as inventory to both make markets and for hedging purposes, it is not in their interests for index-tracking ETFs to deviate in tracking error and performance.
Additionally, as fund holdings are publicly available information, it would quickly become evident for all to see if an ulterior motive were at play here, further disincentivising a fund manager to act in such a way.
Data, as provided by multiple issuers, shows custom baskets in that 2020 period did in fact include a variety of securities that were accurately reflective of the underlying holdings of each ETF. This backs the argument that there are effective incentives in place to keep tracking error as low as possible.
Here, importantly, we are reminded of the fiduciary responsibility of investment managers on behalf of their investors, and the pre-defined policies and procedures for the construction and negotiation of custom baskets are subject to, all of which are bolstered by stringent UCITS guidelines.
With these factors in mind, we can directly address the possibility of a conflict of interest between the AP and the ETF issuer. The evidence suggests that the agreement of the ETF issuer to a detrimental basket that is not in the interests of shareholders is, in fact, highly unlikely, and impractical as well as it goes against the objectives of the fund.
The market structure and market incentives effectively protect existing shareholders, most notably with the incentive to minimise tracking error at the core of the ETF structure.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here