The COVID-19 pandemic has emerged as a grave threat for both global health and the economy. The impact on health has been drastic, with millions affected and thousands dead. The economy has been equally badly hit, with many countries projected to witness a sharp fall in GDP. Financial markets are rattled, with global equity indexes falling more than 30% from recent peaks.
Governments and businesses have responded to the crisis primarily by enforcing social distancing and lockdowns. These preventive measures can profoundly affect operations, sales, business confidence, and consumer / investor sentiment. We look at the financial, operational, and regulatory challenges faced by the passive investment industry – ETF / index sponsors – due to the COVID-19 pandemic.
Impact on financials
ETF providers were already facing cost pressure, due to falling revenue, before the start of the pandemic. The asset-weighted average expense ratio of equity ETFs had declined by 30% to 20 bps in the 5-year period ending 2018. Similarly, for bond ETFs, the decline was 38% in the 5-year period ending 2018. Since the revenues of both ETF providers and index sponsors are closely linked to fee derived as a percentage of assets under management (AUM), the impact of market falls can be significant.
Markets across the world have fallen by more than 30% in response to the COVID-19 pandemic. The fall has been even more substantial in the case of commodities such as oil. The pandemic has also affected investor sentiments negatively due to multiple factors, including rising unemployment, cash crunch, falling consumer confidence, and economic slowdown.
Typically, investors move out of equities during market volatility, especially when there is uncertainty about the future. This results in net fund outflows for ETF / index providers, reducing AUM and revenues. Also, uncertainty over the future translates into lower investment outlay and more cash holdings in investment plans. These factors are likely to have a higher impact on players with a high level of fixed costs as well as those with a high share of equity products.
New business approach under new circumstances
To mitigate the impact of COVID-19 on financials, ETF / index providers can focus on developing a diversified product portfolio, with a lower share allocated to risky asset classes, such as equities and commodities. Product offerings such as liquid-alts, which are less likely to be affected by market downturns, will provide some stability in these testing times.
ETF / index providers can also focus on developing digital ETF investment platforms and holistic solutions, with a comprehensive portfolio and analytics offering catering to young and tech-savvy customers, in order to grow their revenue with minimal human interaction.
Besides these, players can focus on product differentiation through research and marketing, in order to overcome the competition and introduce niche products, such as thematic indexes / ETFs, to be able to command higher fees.
To minimize costs and improve focus on core activities, ETF / index providers can look at outsourcing non-core activities, such as index calculations, database maintenance, corporate action adjustments, fund accounting, NAV calculations, etc.
Impact on operations
Governments and firms are using lockdowns and social distancing as strategies to combat COVID-19. However, this is creating challenges for firms that need to maintain continuity of operations through remote working (as opposed to traditional physical office setups). These changes have the potential to impact employee morale and productivity.
The volatility across markets has given rise to unique challenges, such as market disruptions and pricing problems, price change by pricing sources (including exchanges), and restatement of major index prices used in portfolios. Since the profit & loss of trading desks are linked to these prices, there could be errors in their calculations.
An increased number of corporate actions have also been affecting equity index calculations. In the commodity space, index providers frequently face disruptions, which lead to delays in price and index calculations. At present, delays are being faced and recalculations undertaken by every index provider due to rebalancing triggered by market volatility. A fall in prices is creating more stress for index providers, who have to make sure their indices are in line with market movements.
The emerging situation is also leading to an increase in defaults in Credit Default Swaps markets (especially high yield markets), causing disruptions in CDS calculations. Moreover, crude oil futures traded at negative recently, resulting in a major problem for index / ETF providers, who are struggling to find a feasible way to handle a situation they have never encountered before. Legal index / ETF documents do not cover such situations, and ETF providers are struggling to arrive at correct NAV calculations amid abnormal prices. They are also facing difficulty in index-tracking due to an increase in transaction costs (higher bid / ask spreads) and decreased liquidity.
Geographical and technological diversity as an advantage
To preempt disruption of operations, index / ETF providers can look at creating a diverse base of vendors / offices rather than being concentrated in one region. They should create strong business continuity plans, covering areas such as remote working, multi-tasking by employees, contingency planning for key employees, delegation, etc., for themselves as well as their vendors. Robust index / fund documentation, in response to abnormal market conditions, will help in providing prompt responses.
Continuous engagement with employees is the need of the hour. Fortunately, technology has come to the aid of businesses looking to enable remote working. New-age technologies, such as video conferencing, cloud computing, blockchain, virtual reality, automation, artificial intelligence, advanced wireless communication technologies, etc., can continue to ensure smooth business processes.
Impact of increased regulatory requirements
Due to the COVID-19 crisis, ETF / index providers might face some difficulties in complying with regulatory requirements. For example, due to adverse market conditions, an ETF might deviate from the stated investment goal of investing at least 80% of its assets in an underlying index. Temporary measures, such as a ban on short-selling, increased margin restrictions, and shutting down of markets might also stop ETFs from fulfilling their stated objectives.
Moreover, ETFs may need to provide additional disclosures due to risks arising from the pandemic. In times of market distress, providers may also need to comply with enhanced investor communication requirements. Apart from that, protectionist measures by governments (such as anti-immigration laws, localization of workforce, foreign investment restrictions, capital repatriation controls, etc.) can also impact their business. Another challenge is an increased security threat and the need for surveillance due to remote working.
Planning, communication, and automation to the rescue
To face regulatory challenges, ETF / index providers can resort to advanced planning to deal with the current and similar future scenarios. Regular communication with investors and regulators can help mitigate the impact of regulatory challenges. Moreover, they can use automation / technology to speed up processes and reporting, and adopt cybersecurity measures and multi-factor authentication in the wake of increased cyber threats.
In a nutshell, we believe diligent planning, use of third-party vendors, and judicious use of outsourcing and technology can minimize the impact of COVID-19.
Here are a few client success stories of ours - check the link below to see how we helped ETF / index providers overcome their business challenges.