ETFs on the rise as underlyers, but shortcomings remain in costs, tracking errors, hedging

By Emma Trincal

New York, Nov. 23 - Issuers are increasingly using exchange-traded funds for the packaging of structured products, a trend some said should benefit banks and investors alike - but others remain more skeptical.

Structured products linked to ETFs amounted for 4% of this year's total issuance with $1.35 billion out of $33.38 billion compared to 2.8% for all of last year with $1.71 billion out of $60.73 billion, according to data compiled by Prospect News.

"We're seeing more and more structured products based on ETFs but the vast majority are still based on indexes," said Richard Ciuba, senior director of sales in Americas at Dow Jones Indexes

"People have been running ETFs as underlying for a number of years," said a sellsider. "And it's true that ETFs offer some advantages."

Popular names

One of such advantages, the sellsider noted, is the visibility of the reference asset.

"Sometimes, investors prefer to own a commodity ETF rather than an index, for instance they would want GLD [SPDR Gold Trust], which is very popular, because you can type GLD in Yahoo! and check the price while indexes are based on futures," he said.

The use of ETFs as the underlying may be beneficial to small-size issuers, he added. "If you're a financial institution that only has equity hedging capacity, an ETF would allow you to issue products that you can hedge using equity, so it may end up being cost efficient."

For impenetrable markets

Dow Jones' Ciuba said that ETFs may be the vehicle of choice for structurers putting together exposure to hard-to-reach markets or non-liquid asset classes.

Structurers trying to replicate an index need to hedge that exposure, he said, adding that it involves using options and futures or purchasing the securities directly in the appropriate weight to mimic the index. The liquidity of ETFs helps with the cost of trading and hedging," he noted.

"Buying the securities outright may be very difficult for them if they don't have the custodian relationships, or the trading relationship or if they don't have access to that market or if the market is not liquid enough," Ciuba said, giving as examples India and China. "Using ETFs may help reducing costs and it adds ease of tradability."

Not an asset class

But others are more skeptical, saying that they don't foresee ETFs becoming more prevalent than indexes as the underlying of structured products.

"ETFs are not an asset class. It's an investment class," said Keith Styrcula, chairman of the Structured Products Association.

Some problems

Styrcula said: "I am not sure there is an industry there," simply because the cost of hedging ETFs is too high.

"The fees might be too expensive. You have fees plus fees on the underlying funds. To be sure, the liquidity of ETFs makes it a good hedging device. But if you have to pass on the fees to the investor, I'm not sure it's going to be a big business," he said.

For others, the problem with ETFs is their potential tracking errors.

"I don't really know if it would represent an extra cost but I know that you find discrepancies between the ETF performance and the basket of stocks or commodities they're supposed to track," said Matthew Bradbard, president of MB Wealth in Fort Lauderdale, Fla.

"That's why I don't trade ETFs. There is a problem with performance. Most of them have underperformed the index. Gold futures, for instance, have done better than GLD," Bradbard said.

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