The near-death experience of AIG has raised the issue of credit risk everywhere, including the homes of ETF investors who thought they had no direct exposure. Owners of exchange traded funds linked to the insurer’s popular commodity indices were surprised to learn that the downgrading and near collapse of the insurer would have implications for them too, as ETFs are supposed to bear only the credit risk of the issuer, with AIG merely the sponsor of the index their products follow. AIG’s troubles, however, spilled over as market makers of the ETFs abandoned trading in the funds sold as equity instruments and traded on stock exchanges for a week, even after the announcement of the US government’s $85 billion bail-out.
The problem for holders of ETFs tracking the Dow Jones AIG Commodity Indexes, was that their ETFs were backed by matching contracts from AIG Financial Products, guaranteed by AIG, and that the loss of confidence in the insurer meant that market makers ceased trading with it, even though the firm continued to perform all its obligations related to the index.
Although the London Stock Exchange temporarily suspended trading in Dow Jones AIG-linked exchange traded funds issued by ETF Securities, where trading wasn’t officially suspended closing prices plunged as some institutional investors took advantage of the confusion to scoop up shares from panicked retail sellers at exceptionally low prices. Shares in ETF Securities’ Dow Jones AIG Agriculture Index fund listed in Paris, for example, fell more than 25% in one day, far greater than the index itself.
The net asset values of the funds, however, were unaffected. "It is important to distinguish between the net asset value of the funds and their trading price," explains Nicholas Brooks, head of research at ETF Securities in London. "Bid-offer spreads for funds linked to the Dow Jones AIG Index were affected, along with the prices of many other assets, as financial market liquidity tightened in reaction to the severe turmoil in the US financial system and concerns about AIG. Despite the impact on trading prices, the NAV of the funds continued to track the underlying indexes consistently."
The debacle also brought to attention the previously unrealized practical difficulties involved for investors wanting to redeem their ETFs. Rather than turning to the issuers of their ETFs, investors seeking redemptions had to contact settlement registrars directly.
Although trading has recommenced in all the affected funds listed in Europe, the surprise suspension of trading and the issues it shed light on are likely to shake the confidence of retail investors in the product and refocus investor attention on the way exchange traded funds work and the financial strength not only of their issuers, but their index sponsors as well.