2017 should be the last year for the short-term savings sector in Israel in its current form. If the upcoming reform to the domestic Exchange Traded Notes (ETN) industry be applied on schedule (January 1 2018), the Israeli market will say goodbye to its most popular index product.
This regulatory change affects nearly NIS 100 billion of domestic public funds and industry participants. At the end of the process, the mutual funds industry in Israel will also experience a tremendous change and have active funds alongside passive funds.
Why remove ETNs from the market?
In May 2000, Ofek Leumi Financial Instruments, a former subsidiary of Bank Leumi (TASE: LUMI) and nowadays, a company named Psagot Sal, launched an innovative product that aimed to provide investors with full replication of an index. The Tel Aviv 25 Index was chosen to be the first index which would be tracked through a domestic ETN.
During those years the US market offered a product with a similar purpose to Israel's ETNs - Exchange Traded Funds (ETFs). However, the essential difference between these two index products was and remains their legal structure.
While the ETF belongs to the world of mutual funds and guarantees investors with all rights derived from the underlying assets of the tracked index, ETNs have a legal structure similar to corporate bonds. In other words, the investor is exposed to credit risk, meaning there is a possibility an ETN issuer will not be able to fulfill its obligations to the investors.
This risk is defined by the Israeli Securities Authority (ISA) as a major threat to the stability of the Israeli market and for this reason, the ISA seeks to remove ETNs from the market by changing the Joint Investment Trust Law in Israel. The upcoming amendment aims to convert ETNs from a debt obligation to an equity instrument - a mutual fund. This process should occur towards the end of this year and be completed by the start of 2018.
Where are we now?
The current numbers of the ETN industry in Israel show how complicated it is to fully implement this procedure. At the end of 2016, the industry, which consisted of four issuers that used 21 subsidiaries for their activities, managed net assets of NIS 96.1 billion ($25 billion) in 687 ETNs.
This means that there is a need to change the legal structure for a large number of companies, update hundreds of prospectuses and adjust tens of billions of shekels to comply with the mutual fund regulations in Israel.
The number of ETNs has increased dramatically over the last few years as has the amount of assets under management. Two-thirds of the ETN industry in Israel track equity indices, most of them global equity indices (39% of total industry assets). Bond indices, particularly domestic corporate bonds, make up another 25% of the industry. Other ETNs track commodity indices or complex ETNs, leveraged ETNs or reverse (short) ETNs.
What will happen following the amendment?
Assets under management in the current industry are divided into four issuers, three of them (Tachlit, KSM and Psagot) have a similar market share.
However, in order to examine the passive investing products market in Israel after the implementation of the upcoming amendment to the ETNs, we must add another component to the equation - tracking index funds. That’s because the reform will result in two different index products, which the mutual funds industry in Israel will be allowed to offer: tracking index funds and ETFs.
The main difference between these two products will be the way they will be offered to investors. While investing and redeeming shares of tracking funds will be the same as “regular” open-ended mutual funds in the market, meaning limited to one transaction per day, ETF trading will take place throughout the entire trading day on the Tel Aviv Stock Exchange, similar to ETFs trading globally.
The first tracking funds in Israel were launched in 2008 but most mutual fund managers did not promote them until 2011. Therefore, the total AUM of this product in its early years was a few billions only.
In 2012 began the golden era of the tracking funds in Israel, which resulted in net inflows of about NIS 20 billion ($5.3 billion) by the end of 2015. At the same time, the number of products crossed the threshold of 100 and now there are 277 funds tracking indices both domestically and globally.
5 dominant index providers
Currently, there are seven mutual fund managers offering tracking funds, of which four belongs to entities that also offers ETNs. When combining the two current index products in the market into a joint industry under the new structure (tracking funds plus future ETFs), we get five dominant companies with total assets of more than NIS 10 billion each of index products.
Using the numbers at the end of 2016, the future merger of Israeli ETNs with tracking funds creates a new arena with NIS 123.7 billion ($33 billion) in assets and a 40% market share in the short-term savings sector in Israel. By comparison, active mutual funds are currently managing NIS 168 billion ($44 billion), representing 54% of this sector.
Accordingly, if the reform was implemented today, the number of index products in Israel was 892, 70 less than the current amount of the two industries. The reason for that is duplicated ETNs that were created due to past mergers and accusations in the ETN industry in Israel.
On the other hand, it is likely that as part of the preparations for the final implementation of the amendment, industry participants will build up their product portfolios to fit the new market. So, we should see in the near future massive tracking fund launches, as in the future, fund managers could decide whether to keep the product in its original structure or to convert it to an ETF.
Therefore, it may well be that the day after the reform in Israel's ETN Industry, the domestic market will offer investors about 1,000 different index products, a number which certainly puts the Israeli market on the world map in terms of passive investment products.
The author is founder and CEO at Index Research, an Israeli-based index provider specializing in research and development, calculation and maintenance of fixed income and equity indices.
Published by Globes [online], Israel business news - www.globes-online.com - on January 29, 2017
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