Macquarie: The Behind-The-Scenes ETF Player

Australian financial services group, Macquarie and its competitors are important as they seed new funds, create liquidity and help determine the dominant providers  

Editor, Europe
Reviewed by: Rachael Revesz
Edited by: Rachael Revesz

It’s all very well talking to the end investor and the product provider, but what about the people behind the scenes? After all, the banks are responsible for getting new products off the ground, for creating that underlying liquidity, and they play their part in determining the end cost for the investor. Also, their building of relationships in the market goes a long way to explain why providers like iShares continue to have such dominance in Europe.

Macquarie Group, which works as a market maker, custodian, seed capital provider and advisory firm, is one of the major players in the exchange-traded fund (ETF) industry, even if it appears as less visible to the buyer of the end product. spoke to Macquarie’s global head of ETFs, Morgan Potter, and head of ETF sales, Chris Johnson to discuss “true” ETF liquidity and due diligence, concentration risk and what the future looks like for synthetic ETFs. I understand that providers in Europe need more and more money in seed capital to get a new product off the ground– is that the case and if so, why?

Johnson: If you have a broad-based fixed income fund, for example, it becomes very difficult to track the index with sub $20 to $30 million, and getting that seed capital is tough, as the cost of capital is higher these days.

But as to the question of what constitutes critical mass – that depends on the market. Depending on the issuer and the fund structure, profitability maybe means $50 million in the fund, whereas other issuers might need $100 million. And then there are thresholds you have to consider for distribution – like to get a product on a retail platform you usually need $25 million.

Potter: We are regulated by an Australian entity so we can’t hold a seed position longer than six months as after that they will treat it as an investment position which attracts different capital charges.

We only seed to help the issuer. So, BlackRock is an important counterparty for Macquarie globally – their active management business pays various parts of Macquarie so it’s an important relationship for us to foster. If the provision of seed capital is very important for their iShares business then yes, we will make that decision.

If it’s a new asset manager looking to grow a business, then we look at their marketing strategy, their plan: it’s an investment decision for us as to that counterparty but it’s nothing to do with making money from that seed, it’s purely a relationship. Is there concentration risk for an adviser if a bank or institution provides the majority or all of the seed capital for a new ETF?

Johnson: This is the thing that a lot of the platforms may look at. Advisers who sit on the platform will do that due diligence process. It’s frankly a hurdle. In the early days of a fund, to your point, the seed partner will be the only holder. […] You may not know who the other holders of the product are for at least a quarter. Hopefully the seed gets sold out into the secondary market to other holders. That typically doesn’t then get reported for some period of time. This is why a lot of advisers and platforms will not buy a new fund for six months or longer.

It’s not a really valid way to do due diligence in my opinion as given the nature of ETFs, their ability to create and redeem, and their whole regulatory structure and oversight, you really don’t have the same risk as perhaps you would in an active fund or hedge fund if there are limited holders of the product. If an ETF is liquidated you can always get out at NAV (net asset value). Is that true that an investor can always get out at NAV?

Johnson: If it’s an ETN (exchange-traded note) or ETC (exchange-traded commodity) all bets are off as it’s structured as a debt obligation of the issuer. If it’s an ETF and holds physical securities, you should be able to [get out at NAV] as you’re the last one holding the product. You might find challenges trading it in the secondary market but you should be able to go back to the primary market and get out of NAV. It’s the beauty of the ETF structure. You’ve had a business in Asia dealing with ETFs for two years now. What developments and changes are you noticing in the China A-shares ETF market?

Potter: There’s a huge amount going on. It’s all about opening up China and liberalising access.

The volume changes in China have been enormous in terms of the value traded. The retail market and various syndicates are pushing domestic assets around, and you can trade them via ETFs in Hong Kong. So there’s an arbitrage there that people have been taking advantage of, due to the RQFII (Renminbi Qualified Foreign Institutional Investor) programmes and the Stock Connect programme which has allowed people to trade the physical ETF.

There has been a swing away from the synthetic ETFs because you can’t access the underlying and there’s problems around not being able to redeem, create, etc. Why do those physically replicated China A-share ETFs that were not first off the bat struggle to gather assets now?

Johnson: I think first-mover advantage is critical in these products. If you’re out first, marketing these products, you get the snowball of liquidity, and when people screen these products they look for the biggest and which trades the most and then they stop. Not everyone does that deep due diligence.

But I think you should be looking at it from an investment case first, matching benchmarks to your objectives, then look at the details around the true liquidity, not just the perceived liquidity on screen. You shouldn’t just take the easy road and buy whatever is biggest. Journalist Robin Powell wrote on our website this week that the industry is missing the point of ETFs and not realising whose benefit they should really be for. Do you think the industry is missing who ETFs are for?

Potter: As Chris says, everyone has a different objective and mandate. Trying to match that to an ETF is difficult: there is a big shopping list to purchase out there. ETFs make it easy to buy. But for example, there’s a huge standard deviation of returns across all crude oil ETF products. You can have huge alpha performance on one [ETF] but it might just be luck unless you dig into the detail. Yes, they are simple, they trade on exchange, there’s always liquidity, but the return differences are quite variable depending on which ETF you choose. What does the future look like for synthetic ETFs in Europe?

Johnson: There are some advantages to this structure. And at times there is no other way to do it. Look at China A-shares, prior to RQFII – foreign asset managers could not necessarily get their quota through the government schemes, so synthetics gave access to that asset class which wasn’t otherwise available.

Another reason to have them is that it’s a lot easier to launch a synthetic funds with lower asset levels. If you launch a physical fund with not much money, tracking a broad index, you have to over-optimise the fund which ends up with tracking error risk. Those two reasons make them reasonable and they should continue.

Broadly speaking, there has been a lot more scrutiny around swap futures due to the variability of their structure, from funded to unfunded, with perhaps one bank acting as the entire value chain. I think investors have wised up to that process. And scrutiny is good and healthy and causes improvement. But physically replicated ETFs, where it makes sense, will grow.

Rachael Revesz joined in August 2013 as staff writer. Previously an investment reporter at Citywire, she has a background in writing content for retail financial advisors and has covered a wide range of subjects in finance. Revesz studied journalism at PMA Media, which has since merged with the Press Association. She also holds a B.A. in modern languages from Durham University, as well as CF1 and CF2 financial planning certificates from the CII.