A Swap-Based ETF Checklist
– November 08, 2010
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In Europe, exchange-traded funds using derivatives to track their underlying index now outnumber those using traditional, physical replication by around two to one. However, a close examination of swap-based ETF structures reveals some significant differences, notably regarding collateral policy, swap reset frequency, swap fees and the taxation of dividend income from the underlying securities.
We have therefore put together a checklist that investors can use when evaluating and comparing exchange-traded funds from different providers.
The swap counterparty exists to guarantee ETF investors their index return (after fees). Assessing the direct credit risk of swap counterparties is relatively straightforward, even if obtaining the relevant information may require some legwork if you don’t have a Bloomberg subscription.
For example, investors can refer to the credit default swap spreads of the swap-writing banks for an indication of both absolute and relative credit risk. Banks’ asset swap spreads are an alternative measure (asset swap spreads show the price of credit for a bond issuer, expressed as a margin over the wholesale interest rate).
Swap-based ETFs may have single or multiple counterparties. In the case of the multiple counterparty swap-based ETF structure (as offered by issuers Source, ETF Exchange, and in iShares’ latest swap-based funds), rules exist both to ensure diversification between counterparties and for counterparty replacement if one fails to perform its duties. But ETF issuers using the single swap provider model argue that they can internalise certain costs and ultimately provide investors with a better deal (see point 4 below).
Europe’s UCITS rules, which set the risk management policy to be followed by almost all the region’s ETFs, specify that net exposure to derivatives counterparties may not exceed 10% of a fund’s net asset value.
Collateral is therefore used to reduce ETFs’ exposure to their swap counterparties.
How collateral policy is enforced within the overall UCITS framework is down to the individual regulator in the country where the fund is domiciled. For most swap-based ETFs, this means Ireland or Luxembourg, though there are also swap-based ETFs resident in both France and Germany. In practice, differences in domicile can lead to some differences in the actual rules set.
The Irish financial regulator, for example, did not allow equities as collateral for swap-based ETFs until early this year. When it did, it insisted that equities be subject to a 20% “haircut” (in other words, collateral held in the form of equities should represent at least 120% of the counterparty risk exposure). In Luxembourg, where equities have been permitted as collateral in derivatives-based UCITS (like ETFs) for longer, it’s up to the fund custodian, the fund management company and the fund’s directors to set any haircut for equity collateral.
The reset policy for the swaps backing a fund can also have an effect on the overall level of collateralisation. Some ETF providers reset their swaps only quarterly, others according to a more frequent schedule, including daily. The minimum level of collateralisation required to trigger a swap reset can vary from the UCITS-prescribed minimum of 90% to 95-97% in some cases, while the level of collateralisation reached after a reset can also vary, from under 100% to 120%.
The overall level of collateralisation reached as a result of all these considerations can, in turn, also reflect differences in a swap-based ETF’s structure (see point 3 below).
If you imagine liquidating a swap-based ETF’s collateral after an insolvency event, the actual make-up of the basket of securities may impact your ability to do so. A collateral basket containing Japanese equities will require you to wait until Asian trading hours to get best execution on a sale, for example.
Owning bonds as collateral may sound safer in theory than owning equities, but is it in practice? If your bond collateral performs differently to the index you’re tracking, you’re exposed to correlation risk.
Two swap-based ETF issuers, Credit Suisse and iShares, now disclose their funds’ collateral baskets daily on their websites. Other providers offer this information only at six-monthly intervals (in their funds’ annual and semi-annual accounts) or on request.
More frequent disclosure is undoubtedly better from an investor’s perspective, if only as a form of reassurance that good quality assets are being held to back the swap counterparty’s promises.
Can the structure adopted by the swap-based ETF affect the security of an investor’s interest in a fund? There’s a difference between two groups of European ETFs that’s worth being aware of, say some fund providers.
In the first case, money entering the fund after an investor’s subscription is used to buy a selection of shares, representing a basket of collateral. The return on this basket is then exchanged (via an “unfunded” swap) with a counterparty for the return on the index.
In the second case, the money entering the fund is paid directly across to the swap counterparty (in a so-called “prepaid” or “funded” swap). The counterparty contracts to pay the fund the index return, as well as pledging collateral to the ETF’s account at the fund custodian.
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