Cash is supposed to be the safest asset class, yet interestingly it was the banks that were at the heart of the financial crisis. Had governments not stepped in to save banks then depositors would have learned the hard way that cash is only as safe as the bank that it is deposited with.
By contrast, company shares are considered the riskiest of assets and yet the collective investment vehicles (units trusts, investment trusts and open ended investment companies) that are commonly used by investors to hold shares on their behalf, kept investors assets completely safe (albeit those assets obviously fell in value). Of course, collective vehicles are not anything new; Foreign and Colonial created the first investment trust in 1868, while M&G launched the first unit trust in 1931. These are tried and tested investment vehicles which have protected investors for over a century.
I am often asked by clients – how safe are the collective investment funds that we recommend? Please be reassured that these funds keep your assets completely safe. I always recount the story of Barings Bank brought down by Nick Leeson. Ironically, depositors in Barings were the least protected, while investors in Barings’ funds were completely safe. This is because the collective investment vehicle structure is built on a separation of asset ownership, asset custody and asset management. Barings were simply managing assets on behalf of their fund-holders and they had absolutely no access to the underlying assets.
Exchange Traded Funds (ETFs)
Over the last decade or so, a new investment structure has evolved that now competes with collective investment vehicles – the Exchange Traded Fund (ETFs). ETFs do have many advantages over more traditional collective vehicles, for instance they are continuously priced throughout the day which is an enormously useful innovation for a trader.
However, there has been a lot of adverse press about ETFs recently. The Financial Conduct Authority, Financial Standards Board, Bank of International Settlements and most recently the Serious Fraud Office have all voiced concerns in recent months about certain risks posed by ETFs.
The key point to note is that not all ETFs are the same. There are two main types:
- Physical ETFs are very similar to collective investment funds. As an example, the iShares Developed Markets Property Yield fund physically holds all the global property companies in the FTSE EPRA/NAREIT property index. We are entirely comfortable that all the iShares physical ETFs we recommend offer the same extremely stringent level of protection as the more traditional collective investments.
- A second type of “synthetic” ETF is typically managed by investment banks who promise to swap the return of the index they track in return for a management fee. Like a bank deposit, this adds counterparty risk (the risk that the bank fails and cannot make good on its promise).
The recent concerns from regulators lie more with these synthetic ETFs. Commodities futures exposure is the only asset class that we recommend which falls into this category (via ETFS and Deutsche Bank funds). Although in theory this does entail counterparty risk, in practice the funds we recommend are governed by extremely rigorous UCITs III regulations, which impose strict limits on minimum collateral to be held with a third -party custodian to protect against this risk. This regulation requires minimum collateral of 90% or maximum counterparty risk of 10% of the invested capital. In practice the funds we recommend post collateral in excess of 100% to provide greater protection than the minimum that is required.
Clients may remember that this protection was tested during the financial crisis. The ETFS All Commodities fund counterparty was AIG. AIG were, of course, one of the biggest victims of the crisis; however, the collateral protection worked and UBS have since replaced AIG as the counterparties providing the index return to ETFS All Commodities investors.
There is one other final area worth covering on the issue of asset safety and counterparty risk. For a fee, all of the equities funds we use have a policy of lending the underlying company shares held in the portfolio. The stock is typically lent to hedge funds or those that wish to sell those shares “short”, in essence betting that the price of the share will fall. We view securities lending as entirely positive and an area which adds tremendous value for fund holders:
- Both Dimensional and Vanguard return 100% of the fees generated by securities lending to fund holders (most other fund management companies keep this revenue for themselves!). This reduces the fund management charges in our portfolios and is ultimately a source of enhanced performance.
- As an example, Dimensional European Value fund received income in 2009/10 from securities lending equating to 0.22%, effectively reducing the fund charge from 0.60% to 0.38%.
- Securities lending is clearly not risk free – what if the borrower defaults? Both Vanguard and Dimensional have decades of experience in this area, making careful assessments of counterparty risk and imposing strict collateral requirements on borrowers to protect fund holders.
- Securities lending makes particular sense for passive managers, who are not in the game of trying to outperform the market by predicting which companies will do well and which will do poorly. Remember, Vanguard will hold every company in an index. As a permanent holder of shares (they only ever sell a share if it leaves the index), it makes total sense to lend these to earn additional income for fund holders.
- Securities lending and particularly short selling (the opposite side of the transaction) often get a bad press, particularly during crisis periods, but this unquestionably benefits financial markets, by enhancing liquidity in markets, by allowing market makers and traders to hedge their positions, which in turn reduces trading costs and spreads, and by generally improving market efficiency.