Funds & ETFs 

Watch your swap

Low-cost index-tracking exchange-traded funds (ETFs) offer investors a number of benefits, but some of these funds have a complex underlying structure, which is not fully explained to investors. And the proliferation of ETF launches has inevitably caught the eye of the regulators. The latest body to cast a worried eye over the ETF sector is the Financial Stability Board (FSB), an international body that works with national regulators such as the UK's Financial Services Authority (FSA). It has published a report raising a number of concerns about ETFs. Click here to access the report.

The FSB's main concerns are with swap-based ETFs. Unlike plain vanilla ETFs which physically replicate the index by buying the underlying shares, these do not buy the underlying assets in the index. Instead, they enter into a swap derivative contract with a counterparty, usually an investment bank, which agrees to pay the ETF the return of the index.

This may sound like a rather unusual way for a fund to invest, but there are advantages. It can be cheaper to buy one swap than the several hundred shares needed to replicate an index, which would also need changing a few times a year when the composition of the index changed. These cost savings can be passed on to investors through lower annual fees.

It also makes it possible for ETFs to invest in non-equity assets, such as oil, which would be difficult and expensive to store.

But this complex structure introduces new risks, the main one being that the swap counterparty fails to honour its obligation, for example if it becomes insolvent. This happened in 2008 when insurance company AIG, the swap counterparty on some of ETF Securities' funds, became insolvent and the funds had to be suspended from trading. As a result, ETF Securities now uses four swap counterparties on some funds.

ETFs that comply with the European Ucits III fund regulations are not allowed to have more than 10 per cent exposure to the swap counterparty. To achieve this, the fund holds a basket of assets equivalent to at least 90 per cent of its value so, if the swap counterparty fails, investors should get at least 90 per cent of their assets back. The assets, usually referred to as the collateral, do not need to bear any resemblance to the index that the ETF tracks, but should be easy to sell so that the fund can quickly pay investors what they are owed.

Some providers add to the safety by holding assets worth the full value of the fund, or in some cases even overcollateralise.

Not all ETFs are Ucits III compliant, though. With those that are not, the provider does not have to meet these requirements.

Collateral damage?

The FSB is concerned that the collateral used by some providers is of low quality or is not easy to sell, so if the swap counterparty did become insolvent investors would not get their money back. Not all ETF providers disclose to investors what collateral they are holding, so it is not always possible to check. Requests for information on the holdings have been more readily granted to institutional investors than private investors.

"ETF providers should consider enhancing the level of transparency they offer to investors on the entire range of ETF products, especially the more complex ones," says the report. "In particular, they should make publicly available detailed frequent information about product composition and risk characteristics, including on collateral baskets and arrangements for synthetic ETFs and securities lending, to enable investors to exercise their due diligence and promote a better understanding of the ETF market at large."

Some of the main providers of swap-based ETFs in the UK have taken steps to address this. Since last year, db X-trackers has published the details of what its ETFs hold in their collateral baskets on its website, and it updates the information daily. Db X-trackers also has strict criteria on the quality of the collateral - it will only include equities from major developed markets or investment-grade bonds (bonds rated BBB or above by rating agencies, the ones considered least likely to default).

Db X-trackers also ensures the assets are easy to trade - it does not hold more than five days' daily traded volume of any security, while no one security can amount for more than 4 per cent of the value of the ETF.

ETF Securities, meanwhile, has since 1 May published the details of the collateral underlying its range of 25 Ucits III compliant ETFX funds. These funds also have four swap counterparties rather than one, mitigating the problems if one becomes insolvent.

ETF Securities also plans to disclose the collateral holdings on its collateralised exchange-traded commodity (ETC) products.

Eligible securities include AAA-rated government or treasury money market funds, sovereign fixed income from the US (or Europe if it has a minimum rating of AA), and AAA-rated bonds issued by supranational organisations. ETF Securities' funds can also hold equities from developed market indices.

iShares only offers two swap-based ETFs, iShares MSCI Russia Capped Swap ETF and iShares S&P CNX Nifty India Swap ETF, but since their launch last September has posted the collateral they hold on its website, which it updates daily. These funds also have three swap counterparties.

Blame the parent?

Another of the FSB's concerns related to the relationship between the ETF provider and swap counterparty. In a number of cases, ETFs are run by the asset management arm of an investment bank, and in these cases it is usual to use the parent company as counterparty. This is advantageous in that the swap can probably be provided more cheaply. However, the FSB report says that if the parent company is the swap counterparty it could offload its poor-quality or illiquid assets into the ETF's collateral basket. The FSB says there have been instances of unrated bonds and shares being put into baskets, and these can be difficult to trade.

UK providers db X-trackers, ETF Securities and iShares maintain that they do not hold poor assets because of their strict eligibility criteria. db X-trackers does use its parent, Deutsche Bank, as a swap counterparty. However, it says it cannot be pressured into accepting poor collateral, because it is not in charge of this: the management of the collateral is outsourced to a third party, US bank State Street.

Both iShares and ETF Securities use third-party swap providers.

Not all market participants feel that using a third party as swap is the most important requirement. "As long as the ETF fund manager seeks a counterparty that is financially sound and prices the swap competitively, with collateral of sufficient quality, then the identity of the counterparty is not such a concern," says Ben Johnson, ETF strategist at fund research company Morningstar.

While the FSB report raises some valid concerns, it does not mean you should stop investing in swap-based ETFs. But it is important that you understand the underlying structure of the ETF and find out what the underlying collateral is. "As with all forms of investing the investor needs to make a risk/reward decision based on proper due diligence," says Mr Norman. "If you don't understand the product, don't buy it. Also, long-term investors may find open-ended index tracker funds are just as good value as ETFs if they do not need intraday liquidity."

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