Investors face many questions when choosing exchange-traded funds (ETFs) for use in an investment strategy. But, until recently, “What is an ETF?” would not have been one of them.
Most investors are accustomed to the following broad definition of an ETF: a collective investment vehicle that is listed on an exchange and available for continuous trading through the day, but which should always trade at or near the net asset value (NAV) of the underlying constituents. In this way, an ETF combines aspects of a closed-end fund and a mutual fund, and arguably the benefits of both.
The key feature of the ETF structure is the use of so-called “authorised participants” or “APs”, who trade directly with the ETF sponsor (issuer) to create or redeem ETF units. By taking advantage of arbitrage opportunities, APs ensure that the unit price and the NAV remain approximately in line.
So far, so good. But it’s not clear that this basic definition will suffice in the future. There is an increasingly high-profile and polarising debate about ETF structure, particularly in Europe, involving so-called physical and synthetic (derivatives-based) replication.
Some ETF providers focused predominantly on physical ETFs have claimed that synthetic replication may offer greater benefits to the banks issuing these ETFs than to investors. Laurence Fink, CEO of BlackRock—which owns iShares—has gone so far as to say that synthetic replication exposes investors to unnecessary and unadvertised counterparty risks.
In response, synthetic ETF providers claim that their products can offer lower costs and closer tracking while being at least as safe as physical ETFs.
This could be dismissed as a marketing spat. But regulators are also taking a close interest in such questions. In particular, the European Securities and Markets Association (ESMA), the region’s securities market regulator, is set to propose changes to the Undertakings for Collective Investment in Transferable Securities (UCITS) rules, under which most European-regulated ETFs operate.
These proposals, due to be released in early 2012, may see increased restrictions on “structured UCITS”—a classification that includes synthetic ETFs and other funds that employ derivatives. This could lead to an enforced split within the European ETF market.
These developments are making it more important to understand the difference between the two types of ETF and the strengths and weaknesses of each. In the rest of this article, we will review some of the key distinctions.
Physical ETFs, also known as in specie ETFs, are the original exchange-traded fund variant, dating back to 1993 in the US. In its initial form, a physical ETF held exactly the same assets as the index it was tracking; for example, an ETF tracking the S&P 500 index held stocks from that index in a one-to-one relationship.
Today, physical ETFs often have greater flexibility, both in the US market and elsewhere. They may participate in securities lending, which means that at any point in time some of the ETF’s holdings may have been lent out, with the portfolio temporarily owning other assets taken as collateral. This is discussed in more detail later on.
Even where physical ETFs do not lend securities, they do not necessarily hold exactly the same assets in the same proportions as the underlying index. Many follow an optimisation or sampling approach, meaning that they hold a subset of the index assets. That subset is then expected to deliver the same aggregate return as the overall index.
For example, our S&P 500 tracker could hold just 100 shares whose performance is expected to be representative of all 500 index stocks. In some cases, the ETF may also hold securities that don’t actually belong to the index; for example, a fixed income ETF facing limited liquidity in a specific bond may choose to diversify into other bonds with very similar characteristics and expected returns.
Optimisation is usually undertaken in less liquid and harder to track areas of the asset markets, with the objective of reducing trading costs. However, if the optimised basket turns out to have weaker than expected correlation to the index, the optimised ETF may have greater tracking difference either than an ETF that uses more expensive full replication techniques or one using derivatives.
And this brings us to synthetic ETFs. These are more common in Europe than in other global markets. At the end of September 2011, for example, according to Deutsche Bank there were 783 synthetic ETFs in Europe, compared with 427 physical ETFs. However, physical ETFs still held the bulk of invested funds, controlling 59% of overall European ETF assets under management (AUM).
Overall, providers have tended to focus on one type of ETF or the other, mirroring a broader split between asset managers and banks in the issuance of such funds. Out of 35 ETF providers in Europe, 12 only operate physical ETFs and nine only operate synthetic ETFs. Of the 13 that use both types both, five are overwhelmingly biased towards physical products and four towards synthetic ones.
Synthetic ETFs do not invest directly in the assets underlying the index being tracked by the ETF, but instead enter into “over-the-counter” (“OTC”) derivative contracts with one or more counterparties, usually banks.
These contracts promise to deliver the index’s return to the ETF. In Europe, synthetic ETFs often have a single counterparty, which is usually part of the same financial institution that acts as the ETF issuer: for example, Deutsche Bank for db x-trackers ETFs and Société Générale for Lyxor ETFs.
European synthetic ETFs are themselves subdivided into two categories, using unfunded and funded swaps. Neither name is immediately helpful to the non-specialist.
In an unfunded swap structure, the ETF acquires a basket of stocks or other assets, which usually have little in common with the index being tracked.
As the same time, the ETF also enters into two-legged total return swap with a counterparty. In other words, the two parties to the swap exchange the returns they are receiving. In one leg, the ETF contracts to pay the return on the basket to the counterparty. In the other leg, the counterparty pays the return on the index to the fund.
In a funded swap structure, the ETF makes a payment to the swap counterparty, who agrees to pay the index return. The counterparty also pledges collateral to the ETF’s custodian, covering the fund’s net asset value.
A distinction between the unfunded and funded swap structures is that in the unfunded swap structure, the ETF owns the basket of assets whereas, in the funded swap structure, the ETF does not have direct ownership of assets, but has a claim on collateral that has been pledged by the counterparty.