Sunniva Kolostyak: Welcome to Morningstar. The acquisition of Credit Suisse has caused a headache for many active funds. But what about the passive strategies? Here to discuss this today is Monika Calay, our director of passive strategies research at Morningstar.
Monika, thank you very much for being here today. If we start with equity funds first, broadly speaking, how have passive funds been impacted by Credit Suisse?
Monika Calay: Sure. So, globally diversified passive equity funds had very little exposure to Credit Suisse’s stock. At the end of February, the Morningstar Global Index only allocated 0.01% to Credit Suisse. Now, in terms of classification, Credit Suisse is classified under Switzerland in terms of country classification and under financial services in terms of sector classification. So, it’s not surprising that funds offering exposure to Swiss equities or to European financials had a larger allocation to Credit Suisse. In Europe, the iShares STOXX Europe 600 Financial Services UCITS ETF allocated around 2% to Credit Suisse in mid-March. But broadly speaking, if we look at globally diversified passive equity funds, the allocation was small.
Kolostyak: Okay. So, what about passive fixed income then, and ETFs, how were they affected?
Calay: Sure. So, fixed income is where things got interesting. Credit markets were shaken by the Swiss regulator’s decision to write down Credit Suisse’s AT1 bonds and roughly US$17.5 billion were written down to zero, overnight became worthless. Now, just to set a little bit of context around what AT1s are. AT1 bonds were created after the 2008 Global Financial Crisis, and they are the bank’s first line of defense. They are intended to increase capital ratios and to absorb losses, and they are intended to avoid the scenario of taxpayers funding bank bailouts like we saw in the 2008 era. So, they are risky. And you will not find them in most passive fixed income funds because they are ineligible for index inclusion. So, we do not deem this to be a concern currently. However, you can find exposure to AT1 bonds in ETFs. There are several globally. And most of these are active ETFs, but two of them are passive. There’s a product that is offered by WisdomTree and also a product that is offered by Invesco, and they allocated approximately 3% to Credit Suisse’s AT1s. You will find them on some U.K. retail platforms, and I’m hoping that our viewers and our clients are aware that the characteristics of these products are not like your typical investment-grade fixed income fund. They behave more like equities. I think that the recent events really reiterate the benefits of holding globally diversified funds.
Kolostyak: So, are there any other types of funds that have been affected given that Credit Suisse, for example, has been involved as a counterparty for funds involved in securities lending?
Calay: Sure. So, if a fund is physically replicated and it engages in securities lending or if it is swap replicated, then it may have also had some exposure to Credit Suisse. So, if a fund is physically replicated and it engages in securities lending, that means that it owns physically securities, and it may lend those securities out to generate extra income for the fund. This has a benefit, and it may reduce the tracking error of the fund. However, it also carries risk, and this risk is counterparty risk, because there is this risk that the counterparty may fail to return the borrowed securities. Loans are usually overcollateralized, which means that if there is a default, then securities can be repurchased using the posted collateral. So, that’s securities lending.
Now, swap replication. With a swap replicated fund, this fund seeks to replicate the performance of an index via a swap. So, the asset manager engages in a swap agreement with a single counterparty or multiple counterparties. And this type of replication also exposes the fund to counterparty risk. Now, if a default were to occur, then the ETF would be left with a substitute basket of securities. But this substitute basket of securities is not going to hold the same securities as the index that the ETF is seeking to track. It is noteworthy to mention that bank defaults occur very rarely. And in the context of Credit Suisse, it was acquired by UBS, so a default was not triggered. And prior to the acquisition, what we did see is that credit default swaps on Credit Suisse did become inverted, which meant that it was more expensive to protect against a short-term default rather than a long-term default. So, it’s important for investors to be aware that these risks do exist, but that there are measures in place to protect against them.
Kolostyak: Well, Monika, thank you very much for that. For Morningstar, I’m Sunniva Kolostyak.
