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Tag: Financial literacy

The Rise of Passive Management

Over the last decade, there has been a marked decline in actively managed funds in favor of passive management, such as ETFs and index funds. Particularly in the United States, the amount of money flowing into passive management has surpassed that going into active management for several years. In Europe, this trend is less pronounced due to a predominantly bank-based financial system. However, the majority of financial assets are still invested in actively managed funds, accounting for about 80% of the total in Europe.

The volume of ETF management has shown steady and exponential growth, reaching $6 trillion globally and €1 trillion in Europe. In Italy, on the ETFPlus platform, between 20,000 and 50,000 ETF trades are recorded daily. The amount of resources invested in this segment is about €100 billion. The Italian Stock Exchange, being one of the most significant in Europe, competes with the German market in terms of the number of contracts traded and trading volume.

Types of ETP (Exchange Traded Products)

The term “ETP” identifies a set of financial products that share a common goal: to replicate the performance of a benchmark index and to be traded on an exchange. Among these, we can distinguish:

  • ETF (Exchange Traded Funds): These funds are similar to mutual funds and are subject to the UCITS directive. This regulation imposes limitations on the manager regarding the types of investments allowed, promoting risk diversification and increasing investor safety. Another advantage is that the fund’s assets are held separately from those of the issuing entity, protecting investors in case of the manager’s insolvency.
  • ETN (Exchange Traded Notes): These instruments are structured bonds that can replicate the performance of a variety of assets, including more volatile or exotic ones. A specific example of an ETN is the ETC (Exchange Traded Commodity), which focuses on commodities. Unlike ETFs, ETNs are not bound by the UCITS directive, allowing greater investment freedom but with fewer guarantees for the investor, such as in investments in cryptocurrencies or the use of high financial leverage.

ETFs (Exchange Traded Funds)

ETFs are investment tools that, similar to indexed funds, allow investors to expose themselves to specific market indices, which can be geographic, sectoral, equity, or bond indices. These funds passively replicate the composition of an index, strictly adhering to its performance, risk, and return. Their distribution of investments (asset allocation) is closely linked to the benchmark index they aim to replicate. Unlike traditional mutual funds, which are bought or sold at the net asset value calculated at the end of the day, ETFs offer the flexibility to be purchased and sold like stocks during market hours. This allows investors to operate in real-time, with the ability to respond to the current market value through a single buy or sell order.

Difference Between NAV and Market Price

The Net Asset Value (NAV) represents the book value of a fund, calculated as the difference between assets and liabilities. This value is updated daily and expressed in the base currency of the fund.

In contrast, the market price of the fund’s shares is formed in the secondary market through the interaction of supply and demand from investors and is expressed in the currency in which the shares are quoted.

It’s important to note that the market price may not correspond to the NAV of the fund. There are no automatic mechanisms that ensure the alignment of the market price with the NAV in ETF shares, which can lead to misalignments.

These misalignments represent a risk for the investor, who may find themselves buying or selling shares at a price that does not reflect their real value.

An example of this phenomenon occurred during the market crash in March 2020, following the COVID-19 pandemic. During this period, some ETFs investing in less liquid asset classes, such as high-yield bonds, recorded significantly lower quotations compared to their NAV.

Replication Methods

There are two main replication approaches for ETFs: physical replication and synthetic replication, both aimed at minimizing tracking error relative to the reference index.

Physical replication is the most common among ETF issuers and is divided into two categories: full and optimized. In full physical replication, the ETF includes all the securities of the underlying index, while in optimized physical replication, the ETF invests in a representative subset of these securities.

On the other hand, synthetic replication is articulated in two forms: funded and unfunded. In both cases, derivative contracts, such as swaps, are used to emulate the performance of the index. The unfunded version is currently preferred for its ability to reduce counterparty risk. In this model, the ETF and the swap counterparty periodically exchange performances of a substitute basket with those of the index benchmark, adjusting for the cost of the swap, if present. If the benchmark outperforms the substitute basket, the issuer will have a credit towards the counterparty, but in the event of default by the latter, losses could occur for investors. UCITS regulations limit counterparty risk to 10% of the net assets of the ETF, but issuers often adopt additional precautions to further mitigate risk.

The main advantage of physical replication lies in its ability to eliminate counterparty risk through the segregation of assets; however, this method may be slightly less efficient and more expensive compared to synthetic replication.

Costs

ETFs incur various costs, which can be classified into two main categories:

Costs incorporated in the Net Asset Value (NAV) of the fund, thus reflected in the fund’s performance chart. These include:

  • Management fees.
  • Administrative costs, such as custodian bank fees, quote publication, organization of meetings, sending of communications, legal expenses, and other similar costs.
  • Transaction costs associated with the trading of securities within the portfolio or fees imposed by swap counterparts.

It is important to note that management and administrative costs are included in the Ongoing Charges Figure, while transaction costs are not included and can only be identified through EMT flows.

Costs that occur at the time of investment or divestment:

  • The bid/ask spread, which is the differential between the purchase and sale price observable at the time of the transaction of the ETF shares.
  • The costs of executing operations, which are applied by the bank, the Securities Brokerage Company (SIM), or the broker.

It is relevant to emphasize that ETFs do not have entry or exit fees, nor performance commissions.

ETC (Exchange Traded Commodities)

ETCs and ETNs (Exchange Traded Notes) differ from mutual funds in their method of issuance: they are not distributed as fund shares but rather as debt securities. This characteristic excludes them from the category of collective investment schemes defined by the UCITS directive, hence they are not subject to related regulations. However, they can be considered compatible investments for UCITS funds, i.e., they can be included among the assets purchasable by such funds.

Regarding the guarantee, ETCs can be classified into two categories:

  • ETCs with physical replication, which are secured by a physical asset. This type of ETC is typical for commodities that are easy to store, such as precious metals (gold, silver, platinum, and palladium). In this case, the price of the ETC follows the spot price of the corresponding commodity.
  • ETCs with synthetic replication, which instead use a derivative contract to offer exposure to the commodity. These ETCs are generally supported by collateral guarantees, and their value follows the index of future contracts on the commodity in question.

Futures and Rolling Contracts

The future contract is a forward purchase and sale agreement, in this case on commodities. Such a contract allows the purchase of a defined quantity of commodity at a future date, known as “expiration,” at a price fixed at the time of the contract’s stipulation, called the “Forward Price.” The future can also be treated as an independent derivative contract.

In the normal context of Contango, an Exchange Traded Commodity (ETC) may incur losses not directly related to price changes of the reference commodity, but rather linked to the need to continuously adjust positions to maintain the desired exposure.

ETCs that use synthetic replication of the commodity can show significantly different returns compared to the commodity itself, especially if held for medium or long periods. Therefore, it is recommended to use these instruments mainly for short-term speculative operations, on the order of a few days.

ETN (Exchange Traded Notes)

ETNs are financial instruments that act as zero-coupon bonds and are without expiration, designed to track the performance of a specific index. Those who invest in ETNs essentially lend money to the issuing bank, becoming its creditor. This exposes the investor to counterparty risk, or the risk of losing the invested capital in case the issuing bank fails. ETNs may offer collateralization options to mitigate this risk.

These instruments are regulated by the UCITS directive, which allows them to cover a wider range of asset classes or indices than is normally allowed for mutual funds. However, this flexibility results in fewer guarantees for investors compared to the diversification norms typical of UCITS products. For example, ETNs can invest in assets like cryptocurrencies, which are excluded from mutual funds.

ETNs can also incorporate strategies that use financial leverage, aiming for returns that are either positive or negative relative to the reference index, with leverages that can exceed a 2:1 ratio. This means they can amplify gains, but also increase the risks of losses.

Leverage

Leveraged Exchange Traded Products (ETP) are financial instruments that aim to replicate the daily performance of a given index, multiplied by a specified leverage factor. This leverage factor amplifies the daily returns of the reference index. However, for periods longer than one day, the overall return of a leveraged ETP can deviate significantly from the initially expected return due to the cumulative effect of the daily applied leverage.

Leveraged Exchange Traded Notes (ETN) that use leverage or adopt short strategies are primarily designed for short-term trading operations. It is not advisable to maintain these instruments for periods exceeding the duration of a single market session, given their structure and associated risk dynamics.

Mandatory Reporting of Investment Costs: an Overlooked and Little-Known Document

Since January 3, 2018, when the MiFID II (Markets in Financial Instruments Directive II) regulations came into effect, banks, Poste Italiane, brokerage firms, and financial advisor networks are required to provide their clients with a detailed statement of the costs associated with their investments in the previous year. This document, which must be sent by April 30 each year, aims to increase transparency and allow investors to better understand the expenses incurred in investment services.

Despite the importance of this provision, its notoriety among clients remains low. The reasons for this lack of awareness can be numerous. Firstly, banks and financial operators may not be incentivized to widely publicize a document that outlines the often high costs borne by clients’ investments. This could lead to a negative perception of the services offered and, consequently, possible commercial repercussions.

Furthermore, the complexity of the terms used and the very nature of the information presented, some of which are not strictly related to the purpose of the document, can make it difficult for most savers to fully understand the content and significance of the report. This aspect undermines the effectiveness of the regulation, which aims to ensure transparency and enable informed decisions by investors.

On the other hand, mandatory reporting offers clients a valuable opportunity to assess the effectiveness and convenience of the investment services received. Investors can and should use this information to compare costs and services offered by different market operators and check their impact on the efficiency of their portfolio, thus encouraging greater competition and improvement of financial services.

Regulatory authorities, consumer associations, and independent financial advisors play a crucial role in this context. It is essential that they promote greater financial education and push for more effective and accessible disclosure of investment cost information. Only through a joint effort and increased awareness will it be possible to ensure that all investors can fully benefit from the protections offered by MiFID II regulations.

In conclusion, while mandatory reporting represents a significant step forward towards financial transparency, its success depends on effective implementation and the ability to reach investors in a clear and understandable way. It is crucial that all stakeholders work together to overcome current challenges and ensure that every investor can make informed choices about their financial investments.