October 3, 2018 will be a historical day for the Israeli capital market. After a decade of planning one of the largest reforms ever made the short-term savings sector in Israel, the market will say goodbye to its most popular index product - Exchange Traded Notes (ETN) - and will welcome its successor - Exchange Traded Funds (ETFs).
This regulatory change affects nearly NIS 120 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 become a splitter with two heads: active funds alongside passive funds.
Why replace the ETNs with ETFs?
In May 2000, Ofek Leumi Financial Instruments, a past 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 to be tracked through a domestic ETN.
During those years, the US market offered a product with similar purpose to Israeli ETNs - Exchange Traded Funds (“ETFs”). However, the essential difference between these two index products was and remains toady their legal structure.
While 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 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 from that cause, 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 until the beginning of 2019.
The current numbers of the ETN industry in Israel show how complicated is to fully implement this procedure. At the end of April 2018, the industry, which consists of four issuers that use 21 subsidiaries for their activities, manage net assets of 92.6 billion shekels (USD 26B) in 709 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 index products has increased dramatically over the last years and the amount of assets under management. Two-thirds of the ETN industry in Israel track equity indices, most of them global equity indices (46% 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.
Assets under management in the current industry divided into four issuers, three of them (Tachlit, KSM and Psagot) have a similar market share.
However, the index products market in Israel has another significant component - tracking index funds. The result of the upcoming reform to the ETNs is that the mutual funds industry in Israel will offer two different index products: tracking index funds and ETFs.
The main difference between these two products will be the way they marketed 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 launched in early 2008 but most mutual fund managers did not promote them until late 2011. Therefore, the total AUM of this product in its early years was few billions only.
In 2012 began the golden era of the tracking funds in Israel, which resulted in net inflows of about 20 billion shekels ($5.6 billion) by the end of 2015. At the same time, the number of products crossed the threshold of 100 and now there are 347 funds tracking indices both domestically and globally. Since last year, these products manage more than NIS 30 billion ($8.5 billion).
Who will rule the new playground?
Currently, seven mutual fund managers offer tracking funds, of which four belongs to entities 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 dominate companies with total assets of more than 10 billion shekels each of index products.
Using the numbers at the end of April 2018, the future merger of Israeli ETNs with tracking funds creates a new arena with NIS 123.2 billion ($35 billion) in assets and a 37% market share in the short-term savings sector in Israel. By comparison, active mutual funds are currently managing NIS 195 billion ($55 billion), representing 58% of this sector.
Accordingly, if the reform implemented today, the number of index products in Israel was 998, 46 less than the current amount of the 2 industries. The reason for that is duplicated ETNs that 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 execution of the reform, the industry participants would built up their product portfolio to fit the new market. Therefore, we should see in the near future quite a few tracking fund launches, as in the future, fund managers could decide whether to keep the product on its original structure or to convert it to ETF.
That means, by the end of 2018, the domestic market will offer investors about 1,000 different index products, a number that certainly puts the Israeli market on the world map in terms of passive investment products.
Yaniv Kunis is founder and CEO at Index Research, an Israeli-based index provider specializes 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 May 28, 2018
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