JX: At Franklin Templeton, we’re constantly aiming to innovate and push the boundaries, with our exchange-traded fund team often at the centre of this push. In recent years, I’ve tried my best to clear up misconceptions around ETF liquidity, educating our audience on best practices when trading ETFs. While thinking about new ways to tell this story, I realised it might be better to hear from those actively using them in a variety of different roles. Hence, this is my first in a new series of interviews with traders, portfolio managers, risk officers and compliance personnel. They will offer their own perspectives on how they use ETFs, the benefits, and constraints. They’ll discuss how they utilise the ETF vehicle to help them, and their investors, reach their investment goals and objectives.
To kick things off I’m sitting down with Andrew Black, a senior multi-asset trader based in our Edinburgh office.
JX: Andy, thanks for taking the time to talk to us today. Why don’t we start with you briefly describing your role.
AB: Hi Jason. I work on the trading desk with Franklin Templeton’s Investment Solutions Group, where we execute on a wide range of asset classes for our multi-asset, systematic and ETF fund suite. No two days are the same! One day, we can be busy trading foreign exchange options and the next day rebalancing some commodity positions. Excluding the trading, most of my time is spent liaising with various portfolio managers about implementing trade ideas or spending time looking at how we can improve and automate various parts of our trading technology.
JX: Give us some context on your background. You’ve traded through some of the most volatile periods over the last 15+ years—the 2008 global financial crisis, 2015 Greek debt crisis, 2020 COVID-19 pandemic and the current war in Ukraine. What else have you observed from an ETF point of view and how do you believe the ETF wrapper has fared post those events?
AB: Yes, a lot has happened when your look back. When I first started trading in 2004 there were only a few hundred ETFs out there. Now there are nearly 10,000 globally, which is a lot! I guess it shows the appetite and demand is there for low-cost solutions to gain certain market exposures.
I started trading global equities at Martin Currie (now part of Franklin Templeton) before moving to London to work for a large hedge fund. Then, I was off to Dublin for a large asset manager before returning to Edinburgh to work for Franklin Templeton nearly five years ago.
Alongside the growth in the quantity of ETFs has come growth in the number of banks, market makers and ETF liquidity providers who trade ETFs, which has made the pricing so competitive. Because of this, even in strained market conditions those like myself have still managed to trade large sizes competitively when perhaps liquidity has dried up elsewhere.
JX: That’s great to hear and we’ve already touched upon one of the key benefits of ETFs—their ability to provide price discovery and transparency particularly in times of stress. Let’s rewind a little and perhaps you can explain how you use ETFs in your day-to-day role?
AB: Sure. It really does vary for who, when and why we are trading a particular ETF. We have portfolio managers who manage their portfolios at an asset- allocation level. For these funds, we are normally trading daily, whether that is shifting allocations—perhaps by asset class, region or sector—or just managing cash flows. For both scenarios, ETFs are often a featured and valuable tool for us. We also have funds in which ETFs have become a core fundamental holding. Here, we often work closely with the portfolio manager ahead of trading to understand the best way of implementing that strategy/trade idea. This implementation often comes down to utilising either ETFs, futures or over-the-counter derivatives. And sometimes—you’ll love this bit—we have found the cost benefits of the ETF outweigh the cost of trading and holding futures/derivatives.
JX: You’re right, I do love that! So clearly, one of the primary benefits that we as ETF practitioners shout about i.e., cost efficiency, plays into your investment implementation process? Please expand on that point.
AB: Sure. It is sometimes the case, and I stress not always, that the annual management fee or total expense ratio (TER) of an ETF is lower than the cost to trade and hold either futures or derivatives. In the case of futures, we typically need to “roll” futures every month, which not only has a cost associated to it but also an operational element. Futures contracts trade with specific expiry months. “Rolling” refers to extending a position forward, closing the initial near-term contract and opening a new contract with a later expiry date, for the same underlying asset at the then-current market prices. The rolling of futures has an implicit and explicit cost associated to it, along with an operational element. Hence, utilising an ETF if the investment horizon is long enough and the costs are lower makes sense. Equally, if using a derivative, like a swap, to gain exposure, we encounter execution fees plus financing costs whenever increasing or decreasing our exposure. So again, depending on the costs and operational ease, we can often see why investors choose ETFs. However, there are also potential benefits to using futures and derivatives, especially when looking at margin financing (which allows for the use of leverage) and liquidity.
JX: Ah liquidity! A topic very dear to my heart. How do you look at liquidity when trading ETFs?
AB: We fully appreciate that the liquidity of an ETF is based on the liquidity of the underlying holdings. I’m sure if we didn’t, you’d have certainly reminded us. Hence, the on-screen liquidity and size we need to trade will dictate the route to execution. We use a variety of algorithms to directly trade on-exchange, or will typically use one of the RFQ (Request for Quote) platforms to trade at NAV (net asset value) or “at-risk” depending on the portfolio managers preference. We utilise capital markets desks such as yours when needed and can trade with ETF market makers, brokers or investment banks.
JX: Another factor that we always discuss is asset under management (AUM) of an ETF. I always try to educate people to look through to the underlying universe that they’re investing in and appreciate that the ETF is just a window into a deep and liquid pool of securities. For me, it makes no difference if you’re the only holder or the 100th holder. Your ability to increase or decrease your holding is irrelevant to the AUM of the ETF, and hence, the AUM threshold limits applied to mutual funds are wrongfully applied to ETFs. Do you agree?
AB: I completely agree. Unfortunately, I think this will take time and increased exposure and repeating to correct this misconception. Teams such as portfolio construction, compliance and risk have rules they need to follow and unfortunately, this removes certain ETFs from the selection process. They are certainly doing nothing wrong, but as we’ve said earlier, there needs to be a greater understanding about true liquidity and size. This will come with time.
JX: So, what do you see as some of the main constraints with ETFs?
AB: I wouldn’t say there are any structural constraints with the vehicle itself. It certainly does what it’s supposed to do and as you’ve commented on previously, we’ve seen quite a few opportunities to test the robustness of the vehicle itself. I would, however, say that from a trader’s perspective, the fragmentation of the European market and lack of a consolidated tape means headline volume data isn’t as accurate as it could be.
JX: Thank you for sharing your views and giving us multiple examples of the robustness of the ETF wrapper. Andy, it’s been a pleasure sitting down with you and once again many thanks for taking the time to share your thoughts for the Franklin Templeton ETF Capital Markets iView.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.
ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
The performance of derivative instruments depends largely on the performance of an underlying currency, security, interest rate or index, and such instruments often have risks similar to the underlying instrument, in addition to other risks. Derivatives involve costs and can create economic leverage in a portfolio which may result in significant volatility and cause the portfolio to participate in losses (as well as gains) in an amount that significantly exceeds the initial investment. Certain derivatives have the potential for unlimited loss, regardless of the size of the initial investment. Other risks include illiquidity, mispricing or improper valuation of the derivative instrument, and imperfect correlation between the value of the derivative and the underlying instrument so that the intended benefits may not be realised. Their successful use will usually depend on the investment manager’s ability to accurately forecast movements in the market relating to the underlying instrument. Should a market or markets, or prices of particular classes of investments move in an unexpected manner, especially in unusual or extreme market conditions, the anticipated benefits of the transaction may not be achieved, and losses may be realised, which could be significant. If the investment manager is not successful in using such derivative instruments, performance may be worse than if the investment manager did not use such derivative instruments at all. When a derivative is used for hedging, the change in value of the derivative may also not correlate specifically with the currency, security, interest rate, index or other risk being hedged. Derivatives also may present the risk that the other party to the transaction will fail to perform. There is also the risk, especially under extreme market conditions, that an instrument, which usually would operate as a hedge, provides no hedging benefits at all.
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