In the future, however, Bookstaber says he believes Dodd-Frank will improve the landscape: “The legislation will restrict the ability of banks to create complex derivatives just for the sake of doing it,” he said. Central clearing will also “pull derivatives back from the edge” and eliminate what has become an “informational asymmetry between the banks that make derivatives and the investors that buy them.” Reduced complexity and increased standardization will eliminate the information “game” said Bookstaber and that will reduce innovation for the better in this space. Click on the image to watch the entire video.

Today, ESMA will publish draft rules designed to protect ETF investors – although active managers and other industry participants have called for sweeping rules to curb ETFs, those calls haven’t filtered down on the regulatory front, at least when it comes to this first piece of rulemaking.

The focus of ESMA’s rules will be improving the quality of information ETFs provide to investors. They’ll also ask ETFs to disclose their securities lending practices and give greater detail about the securities they hold. The regulator stopped short of handing ETFs the killer “complex” label that would mean investors have to buy them from advisors.

All this is good news for the industry – and it could just point to regulators’ softening stance on exchange-traded products in the future. I think it’s also good news for investors – pushing ETFs into the advisor realm really would have been a huge mistake in my view, especially for a product that has been deservedly lauded as an investment democratizer in the retail space.

Surprisingly, amidst all the disclosure rules, ESMA did not address one factor that has dogged investors and could provide a real risk – tracking error. It happens more than you think in an industry that is meant to provide value to investors by closely tracking an index. Variation in performance on either side of the index can cost investors and it does bear scrutiny by regulators in the future. Will US regulators look more closely at this? Probably not – the most vocal ETF critics haven’t really set their sights on this issue, choosing instead to focus on the role of derivatives and the importance of collateral. However, EDHEC thinks it’s worrying and said so in this paper published last week.

No doubt, ETF providers will now be looking now to US regulators as they produce their own recommendations for the future of the industry. But if ESMA is any indication, it could be a much smoother ride for ETFs that some thought previously.

The morphing of ETFs has caused some trepidation among regulators and market participants. In the U.S., a subcommitttee of the Senate Banking Committee held hearings in October last year to examine whether ETFs have departed so much from their traditional moorings as to become a snare for the unsuspecting.

Eileen Rominger, Director, Division of Investment Management at the U.S. Securities and Exchange Commission notes that ETFs account for $1 trillion in assets, or one-tenth of total mutual fund industry assets. They have a substantial market share and are growing. The problem is mostly how they are growing.

The worry is less with ETFs that hold the underlying shares of the indexes they track. It’s more with ETFs that mostly use over-the-counter swaps to replicate or synthesize exposure to the futures or commodities markets. As a result, the SEC has stopped giving exemptive relief to ETFs that rely heavily on derivative or swaps. As Rominger explains:

“For example, some [exchange-traded products], in the form of commodity-based trust-issued receipts, seek to track an index of futures on volatility of a portfolio of stocks, such as the S&P 500. Futures on volatility have added another dimension to the calculation to express future or expected volatility.  In addition, the Commission has witnessed an increase in the past few years in the variety of actively managed ETFs introduced by sponsors.  For example, while an assortment of actively managed ETFs based on fixed-income portfolios is listed and trading in the marketplace, there have been an increasing number of actively managed ETFs that seek to primarily invest in instruments that raise concerns with respect to liquidity and transparency, including emerging market debt securities, high-yield debt securities, and other instruments.”

Despite the concern, such synthetic pools are a small proportion of U.S. ETF/ETP market, she notes: only 3%. By contrast, they have a 10% share in Europe.

Then again, the concern is very real.  “[B]ecause ETF share prices are dynamically linked to the prices of their underlying holdings, the trading and other characteristics of the underlying portfolio investments, such as certain illiquid types of securities and particular over-the-counter or ‘OTC’ derivatives, may impact the arbitrage process necessary to closely align the ETF share price with its NAV. In certain circumstances, temporary imbalances in supply and demand might result in the price of the ETF decoupling from the value of the ETF’s underlying instruments as the ETF starts to behave more like a stand-alone product whose price responds solely to whatever liquidity is immediately available in that product, regardless of the value of the underlying investments. Under these circumstances, the ETF can begin to trade at a significant premium or discount to the NAV of its assets.”

That’s a theme close to the heart of Harold Bradley, Chief Investment Officer of the Ewing Marion Kauffman Foundation.

“We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses.  When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around. This tendency is especially pronounced for ETFs that are comprised of small cap stocks or stocks of newly listed companies, that generally are thinly traded.”

In his view, this leads to ever more reliance on untransparently priced derivatives.

“High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time. … Consequently, market makers can often only match their positions against futures, options or other ETFs, or they must employ derivatives and synthetic securities.”

The result is greater volatility. Are there solutions? Noel Archard, Managing Director at iShares, the biggest provider of ETFs (now owned by BlackRock) draws a line in the sand:

“While the first ETFs were straightforward, tracking relatively broad benchmarks such as the S&P 500 or individual country indexes, today some sponsors have introduced new products of increased complexity that carry greater risk and may not be appropriate for retail ‘buy and hold’ investors. Products which raise such concerns include so-called leveraged and inverse funds … products that are backed principally by derivatives rather than physical holdings.  These products require a greater  deal of disclosure and up-front work with clients for them to understand investment and structural risks and BlackRock believes that they should not be labeled ETFs.”

The gauntlet has been thrown. Next post: a perspective from Europe, where synthetic ETFs have a much larger market share.

Pension committees are still managing their plans the same way after a decade of tough financial results. The focus remains on asset returns, with little attention on the funded status of the plan. There are many reasons why pension funds have not changed their approach. Committee members have changed over the past decade and have not experienced the financial pain due to the first two perfect pension storms (declining bond yields and equity market returns). Pension committees have also been reluctant to make changes to asset mix due to the fear of being wrong. Moreover, the current approval structure within pension committees does not facilitate quick decision-making and, at the same time, pension committees are not sure what changes they should make.

Dynamic de-risking is an approach where the asset mix of the plan changes as the funded status of the plan changes. Typically, this results in less risk (i.e., fewer equities and more bonds) in the plan as the funded status improves. Dynamic de-risking allows a pension fund to de-risk its plan when it is affordable (i.e., when the funded status improves).

The underlying premise of dynamic de-risking is that pension plans will sell outperforming assets and lock in those gains to reduce the likelihood of the deficit increasing in the future. There are three key factors involved in creating a dynamic de-risking solution.

First, the pension committee pre-approves an asset mix schedule that allows the investment manager to alter the plan’s asset mix as the funded status of the plan changes.

The investment manager then evaluates the funded status of the plan on a daily basis. This allows asset mix changes to be made in accordance with the pre-approved asset mix schedule.

Finally, the plan develops a clearly stated financial objective. This could involve reducing the volatility of contributions by 10% once the plan becomes fully funded. Or it could be a target funding level of 110% for an eventual annuity purchase.

Dynamic de-risking differs from traditional liability-driven investment (LDI) solutions because it does not require plan sponsors to make a one-time adjustment to their asset mix. Instead, dynamic de-risking gradually removes market-based risk from the pension plan based on the plan sponsor’s financial objectives and current market conditions. This gradual approach appears to be more palatable because it provides a balanced approach where investment returns and cash contributions are used to close the funding gap.

Soami Kohly is Vice-president, McLean Budden.

It isn’t that forecasting returns is a useless exercise. The problem is that the time horizon forecasted is too short to be of much use. CNBC and Bloomberg are focused mostly on days, weeks and maybe months at the longest. The long term forecasts directed at institutional investors typically have an annual time horizon. These forecast documents can be interesting to read, but annual is still too short a time horizon for the information to be put to any productive use.

Five years or ten years: now those are useful time horizons. Not necessarily useful from the perspective of tactical asset mix and beating benchmarks, but as inputs to decision-making on more important issues.  A realistic and informed projection of returns for the next decade can be a useful support for decisions about plan design, funding and also asset mix and investment strategy.

In terms of funding and plan design, sustainability and affordability are top of mind issues. Whether discounted at bond yields or expected total fund returns (a debate for another day), the principle question is the same: Will the contributions and investment returns provide enough money to pay pensions, or whatever liability the fund is obligated to pay?

When I look at longer term return forecasts, I am more inclined to give credit to those based on fundamentals. I have less time for forecasts based on opinions, historical returns or a historical equity risk premium. With fixed income, the current yield to maturity is the logical starting point and one can reasonably expect the yield to mean revert to something close to long term nominal GDP growth over time.

Equity return expectations can be built based on current yield, potential GDP growth based earnings growth and reversion to a mean P/E ratio. This type of analysis, performed rigorously by industry participants, comes out with 10-year returns of 2% to 3% for fixed income and 7% to 8% for equities.  A 50:50 asset mix gives an expected return of 5% nominal.

Two things jump out from this analysis:

1. 5% nominal may not be enough return under current scheme arrangements.

2. Equities should outperform bonds by a wide margin over the next decade.

The first challenge is acceptance: get over it. 5% nominal is a reasonable expectation. If it is not enough to pay the bills, then something has to change. Pay out less, collect more, and/or take more risk.

Active managers and hedge funds have long relied on a factor-based approach to build their strategies. New ETFs such as those launched by Russell last year focus on specific factors like beta, volatility and momentum.

Factor-based ETFs offer a way for investors to manage risk based on individual securities without having to employ other strategies like options or futures. For institutions that currently use hedge funds to either mitigate or enhance risk in their portfolios, factor-based ETFs could evolve into an interesting alternative – one that allows institutions to take directional bets on where they think the market is headed, without having to pick individual stocks.

The some are asking is whether or not factor-based ETFs could take market share from the hedge fund industry. Probably not right now. But as they gain liquidity and keep costs low, they could provide some serious competition, especially in the cost-conscious pension space.

Factor-based ETFs have also brought attention back to hedge fund replication, an approach that became popular just before the financial crisis, but fell out of favour as hedge fund returns took a hit during tough times.

Along with Russell, other providers have been getting into the factor game — Credit Suisse has launched several more hedge fund replication ETNs and two startups, QuantShares and FactorShares, are also moving into the space.

Whether or not pension funds will bite remains to be seen – but it’s a compelling approach that they should at least consider moving forward.

CalPERS 2011 returns at a glance:

Public equities returned -12.3% compared to a -12.21% custom benchmark;

Fixed income returned 12.38%, compared to a custom benchmark of 13.91%.

Absolute-return strategies returned -2.29%, compared to a custom benchmark return of 5.6%.

Private equity returned 12.37%, compared to the custom benchmark’s 1.38%.

Thus Occupy Wall Street protestors decried banks that had been bailed out, yet still handed out lavish bonuses to their own employees. This, for them, was evidence of neo-liberalism and financialisation, which guts the truly productive economy in favour of speculation.

More latterly, the Tea Party has warmed up to the theme: private equity makes money by firing workers. At least that’s what one might assume from a recent political video disparaging Republican candidate Mitt Romney, once a prominent leveraged buyout specialist, now the Snidely Whiplash-like  King of Bain.

Which leads to an obvious question: do financial services create value? Certainly the academic wisdom has come under fire. In the two decades leading to the Great Recession, academics had mostly converged on Schumpeter’s view that well-developed financial systems play a crucial role in stimulating economic growth. … In fact, the body of empirical evidence linking causally and positively the depth of financial markets to growth was growing so rapidly that in 2003, in a discussion of a survey on the subject, one author was prompted to conclude that “…In 1993 many people doubted that there was a relation between finance and growth; now very few do.”

That’s from a paper, “On the tradeoff between growth and stability: The role of financial markets,” written for the VoxEu website by Alexander Popov and Frank Smets at the European Central Bank. It’s one of a series of papers VoxEu has published.

The absence of financial intermediation certainly has an impact and is, perhaps, key in the prolongation  of the slump.

“At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly,” note Andrew G. Haldane and Vasileios Madouros at the Bank of England.

“But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.2 As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts …”

Explains Christina Wang, an economist at the Federal Reserve Bank of Boston:  “In particular, how much of the income received by financial institutions is compensation for actual services provided to their customers and how much is merely for taking on risk, such as funding risky loans with short-term borrowing?”

The former is valuable; the latter a passive activity whose profits stem from leverage. But, she says, it is hard to separate the two activities.

“This is primarily because they often do not charge explicitly for services. Instead, they earn a spread between the interest rates received and the rates paid, as well as fees for writing derivatives contracts such as options and swaps. But earning interest is not in and of itself a productive activity that contributes to GDP. This is obviously sensible in the case of passive investors who buy market securities and then merely receive interest or dividends without producing new goods or services.”

Instead, she argues that ‘[t]he basic logic of the method for inferring the value added of bank services is intuitive. First, consider cases where a bank performs a transaction that earns it interest or fees, such as making a loan or underwriting a derivatives contract. We can ascertain what the bank would have to pay (in terms of either interest or fees) to purchase in the market a financial instrument of the same risk characteristics. Subtracting the value of, or interest on, the comparable market security from total income allows one to infer the implicit revenue the bank earns for services above and beyond investing passively in market securities. An analogous adjustment applies for transactions on which banks pay rather than receive interest or fees, such as those related to depositors.”

As a result she concludes that, “[m]aking conservative assumptions, we show that the current official method overestimates the service output of the commercial banking industry by at least 21% (amounting to $116.8 billion in 2007:Q4 for example) and GDP by 0.3% ($52.9 billion in 2007:Q4 for example) between 1997 and 2007.”

Outside the U.S., Haldane and Madouros come to a similar conclusion.

“The headline national accounts numbers point to a significant contribution of the financial sector to the economy. For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009. The trends over time are even more striking. For example, they suggest that the contribution of the financial sector to GDP in the US has increased almost fourfold since the Second World War. At face value, these trends would be consistent with large productivity gains in finance.”

In fact, however, the productivity gains seem illusory.

“But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

“In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance.”

More intriguingly, adds Thomas Phillippon, a professor at the Stern School of Business in New York:

“The cost of intermediation in the US is between 1.3% and 2.3% over 130 years. However, the finance cost index has been trending upward, especially since the 1970s. This is counter-intuitive. If anything, the technological development of the past 40 years – in IT in particular – should have disproportionately increased efficiency in the finance industry. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?”

His answer: excessive trading, as a result of which “the finance industry’s share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billion for the US alone. “

The survey also revealed that 26% of institutional investors said their top challenge in hedge fund investing is meeting performance expectations. In fact, this concern outranked all others by a healthy margin. With that in mind, institutions also reported lower average returns over the year. According to the survey, respondents earned an average annualized return of 6.2% in 2011 versus 9.2% in 2010 and a median annualized return of 5.0% versus 8.1% in the previous year.

Download the survey.