Friday, 25 January 2013

A kiss and tell on Exchange Traded Funds

I have often tried to forget an incident that occurred during my college rugby days, involving one Tom McLaughlin and a misunderstanding of my coach’s emotional cries to “Kiss, kiss, kiss!...for god’s sake, KISS!!” whenever mistakes were made.

The vast majority of us, however, knew this was an infamous acronym that referenced the coach’s sporting mantra - ‘Keep It Simple Stupid’.

Whilst I would agree that getting the basics right provides a great platform for portfolio construction, I believe, just as with sport, if we can harness flair and innovation, we generate the potential for marginal gains in our performance. In that respect, this post attempts to uncover some of the complexities associated with investing in the ‘synthetic’ Exchange Traded Fund (ETF) universe.

Background
An Exchange Traded Fund (ETF) is an open-ended collective investment scheme that can be bought and sold like any other share listed on a stock exchange. Its purpose is to provide instant exposure to an entire index through a single security with a low tracking error and, typically, at a lower cost than actively managed funds.

An alternative approach to ETF construction, rather than holding all, or a representative sample of an index’s constituents, relies on a ‘swap’ arrangement. Synthetic ETFs, therefore, are defined as investments that use swaps to replicate the performance of an underlying index.

The series of transactions involved in a ‘swap’ are detailed in the following flow chart.

 
In this example the ETF manager pays the cash received from the investor directly to the swap counterparty and receives the return of the market in exchange (labelled 1 on the above chart). The swap counterparty then places collateral (other assets) in a third party ‘ring-fenced’ custody account.

If we net off this series of transactions, therefore, the collateral assets become crucial in determining the risk inherent in the product i.e. the collateral effectively becomes our insurance against counterparty default. A decent level of transparency is, therefore, required, and an assessment on the quality of the collateral must be made. In this respect we determine ‘quality’ as liquidity, and the ability to realise the price at which the asset is quoted within the collateral pool.

Another way to compensate the ETF for the risks of not owning the assets outright is over-collateralisation. This requires the swap counterparty to place collateral with a market value exceeding that of the ETF’s value. Over-collateralisation, therefore, helps to protect investors if there is a brief delay accessing the assets and the collateral value begins to fall.

Default of a swap counterparty
Whilst most synthetic ETF providers have a number of safeguards in place to manage counterparty exposure, it is still a risk that cannot be fully eliminated. Therefore, an investor should be aware of an ETF’s contingency plans in the event of a swap counterparty default.

If a swap counterparty comes under severe pressure, most ETF providers will start looking for a swap replacement. In cases where a swap replacement is not available, the ETF provider will have to sell the securities held within collateral pool to satisfy any amount owed by the defaulting swap counterparty.

Keeping it Simple?
We believe, that despite the complexity, robust synthetic construction methods can improve our index tracking performance. This is because, typically, they charge lower costs than the leading physical replicating competitors. We do, however, accept the degree of explanation is elevated. Should we, therefore, simply accept higher costs for an easier ride in the physical replication universe? Well, sadly, these funds frequently conduct stock-lending, meaning many of the same counterparty risks manifest as those in the synthetic space.

It is collateralisation that again mitigates much of the risk associated with stock-lending. I urge readers, therefore, to become familiar with the process, as it is seemingly unavoidable in the exchange traded universe.

What is the quality of my collateral? Am I overcollateralised? If I KISS, will I be missing out on other opportunities? These are the types of questions investors should be asking.

Ben Gutteridge
Divisional Director - Research

2 comments:

  1. If the physical assets are lent out to the market, does the ETF benefit from the revenues (reducing the cost of operation) or does the manager pocket the cash? I think I know the answer!

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    Replies
    1. Excellent question - Ben will post a blog tomorrow on this subject. The short answer is both - long answer to follow.

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