Synthetic exchange traded funds (ETFs) make their returns by entering into a swap agreement with a counterparty rather than buying the assets they aim to track. This means the swap counterparty, usually an investment bank or insurance company, pays the ETF the return of the assets it is tracking in exchange for the return from a basket of collateral the ETF is holding. If the swap counterparty cannot honour its obligation, for example, because it has become insolvent, then the ETF relies on the collateral, usually major market shares and government bonds, to be able to repay investors.
Physical ETFs, meanwhile, buy the assets they track but some of them lend the assets for a fee, to boost their returns. This is also a common practice among actively managed funds such as investment trusts and open-ended investment companies. There is a risk that the entity that borrowed the assets will not return them to the ETF, so it holds a basket of collateral of at least the same value in case this happens.
This means that both synthetic and physical ETFs that stock lend ultimately rely on this basket of collateral. However, ETFs which comply with European legislation called Undertakings for Collective Investment in Transferable Securities (Ucits), have to meet strict criteria and limits in relation to the diversification, while mainstream providers in the UK are keen to point out that they use good quality collateral, for example developed market government bonds and shares traded on major indices.
As well as the quality of the asset, liquidity (the ability to buy and sell) is important, because if the counterparty fails then the ETF will rely on selling this basket of collateral to get investors their returns. Peter Sleep, senior investment manager at Seven Investment Management, has concerns on this:
"When you look at the collateral pools or the substitute you will frequently find that the make up is not as super-safe as claimed," he says. "Super-safe to me implies high quality government bonds - these will probably go up in value if there is a crisis. Investors might be surprised to see that collateral pools are often made up of overseas equities with a long tail of small and frequently illiquid stocks (which will probably fall in a crisis).
"The credit quality of collateral varies from firm to firm. French issuers generally tend to have the best collateral, due to local regulations, which require them to have 75 per cent European Union stock in their baskets. This is usually liquid and easy to sell.
"Other ETF issuers are subject to other country regulations, which they often interpret quite freely, while their desire to avoid complicated cross-border dividends, and tax on dividends, often leads to them accepting a lot of non-dividend paying stock as collateral. As a result of these factors, you will often find that the collateral baskets are made up of a long list of small equities, which many observers would not describe as super-safe - for example, speculative resource stocks, very small shares and financial shares from Italy and Spain. To mitigate these risks they take haircuts of up to 25 per cent, which could be tested in a crisis, particularly if certain stocks are illiquid."
However major ETF providers argue that they take stringent steps to ensure the collateral is safe.
iShares, which lends stock on its physical ETFs, says it has more than one counterparty and only lends up to 50 per cent of the assets in any fund. It also holds collateral worth more than the assets it has lent - up to 5 per cent more in the case of government bonds, and 10 to 12 per cent more in the case of equities, and this is checked and adjusted daily to maintain these levels. iShares adds that none of its clients has experienced a loss in securities lending through borrower default since it started doing this in 1981.
iShares ensures liquidity by only holding 40 per cent of the daily traded volume of one security in a collateral pool against stock lending, so if trading levels are low the ETF's exposure to the security is also low.
Meanwhile, for the collateral in its synthetic ETFs, db X-trackers holds a minimum of 30 securities and maximum weighting of no more than 4 per cent per issuer, while a holding cannot exceed five times its average daily trading volume.
ETF providers are also more transparent than actively managed funds, which typically do not provide details of their stock lending activities on their website, unlike many ETFs. Read more on this
"With both physical and synthetic ETFs, the investor is protected against loss by collateral held, valued and adjusted by the independent custodian," says Christopher Aldous, chief executive of wealth manager Evercore Pan Asset, which uses ETFs in its portfolios. "The composition of the collateral varies from provider to provider, but is not just up to the provider as the collateral - ie, the underlying holdings in the fund - has to meet Ucits rules. The collateral custodian normally has its own policies, too. We don't look at each ETF's collateral every month if the cover policy is clearly laid out, but we do check during our initial due diligence and then have a programme whereby we check periodically thereafter. We have noticed that in most cases the quality and diversity of collateral has improved over time - probably due to input from those of us who carry out due diligence on it. One or two of the smaller players started out with a fair degree of concentration in the collateral basket but have responded to our comments and we have noticed that it is now better diversified."
Mr Sleep adds: "I think collateral is your back-up parachute. Your primary parachute is the credit worthiness of your main counterparty or their stock lending counterparties. You only really need to rely on your collateral if the main counterparty defaults."
