group. As the number of ETF issuers increase, each of them tries to minimize costs and maximize the performance of their products. As ETF provider you have the choice between physical replication and synthetic replication. Let’s consider an issuer will launch a new ETF. The fund should track an index covering the World’s five largest publicly listed stock companies. The ETF issuer could put the clients money into the five stocks by buying them on the exchange or over-the-counter from a market participant. Hence the ETF’s value behaves like the performance of the five stocks. If an ETF wants to track the performance of 20 or 200 stocks it may quickly become difficult and costly. Hence – especially in Europe – the majority of ETF issuers prefer swap-based (or synthetic) replication methods for their products.
What will happen if one goes bust?
A synthetic ETF doesn’t hold the exact underlying index constituents. Instead, it holds a (randomly filled) basket of securities. These securities may be completely different to the index it is tracking – which is an important fact some investors often do not catch correctly. The ETF asset manager typically will enter into a total return swap (TRS) contract in which he gives away the performance of the collateral basket in return for the performance of the fund’s reference index. Eventually, investors have the risk that the swap counterpart fails to fulfill its obligations. As illustrated above, the performance of the five stocks would no longer be provided by the initial swap partner. So what will happen, if the swap counterpart goes bust? Under UCITS, Europe’s regulatory framework for the fund industry, the collateral is used as security in such a case. The collateral basket is made up from stocks and bonds from OECD countries. A collateral shall cover 90% of the net asset value (NAV) of the ETF, so the counterparty risk is 10% of the ETF’s NAV. It is prevalent that ETF issuers use their parent bank as swap counterparty.
Full replication contains similar risks
Counterparty risk appears in both replication methods – full and synthetic. Using full / physical replication counterparty exposure arises when securities are lent out by the ETF. This is quite common in the fund industry no matter even if it is an ETF wrapper or a classic mutual fund. Securities lending generates an extra portion of income. Usually the lending fee contributes up to 40 basis points to a blue chip ETF like the iSharesEuroStoxx50. Each security lending transaction is secured by a so-called collateral. Usually, these securities are sent to a separate entity – mainly a bank with a custody business – which take care of the position and separate the relevant securities by posting it into a special account. In both replication methods, collaterals are generally 102% of the value of domestic shares and 105% of the value of foreign shares. The North American peers still favour on full replication. Full replicated ETFs in the U.S. are regulated under the Investment Company Act of 1940. This act forbids certain transactions and limits the use of derivatives. Also the SEC has stopped approving synthetic ETFs in March of 2010 to study their affects.
Quality of collateral – a turning point
But do investors really know, what’s behind their ETF? Is it even collateralised? What kind of securities are in the collateral basket? A few years ago it was very difficult to find out, how the collateral basket looked like and by how much – if at all – it was properly (over-) collateralised. As today’s investors desire full transparency, more and more ETF providers made their collateral baskets visible on their websites. The recent call of the Financial Stability Board to give more details about assets held in collateral baskets to improve transparency for investors strengthened this claim. As above already mentioned, all synthetic (swap based) ETFs show differences between the underlying ETF and the collateral basket portfolio. One issuer for example collateralises all of its ETFs with a portfolio consisting of stocks out of the German blue-chip index DAX. If investors buy an European bond ETF it is in fact collateralised witha portfolio of German stocks. Other issuers use a broadly diversified portfolio of stocks based on a quantitative optimisation method. Due to the lower correlation of Japanese stocks with other developed countries the outcome of the optimisation will contain a big part of Japanese companies.
Examples of collaterals by issuers:
A look behind the curtain – ETF Securities
As a reaction on the call of the Financial Stability Board to give more details about assets held in collateral baskets to improve transparency for investors, ETF Securities (ETFS) publishes since May 2011 a list of all collateral held as security for investors on its website. The issuer holds currently USD 28.2 billion AuM. First of all the process of collateralisation at ETFS has to be described. We just highlight the collateralisation of ETFs, which are UCITS compliant and don’t focus on the ETPs. Regarding to ETFS’ website they currently have four swap providers. Swaps with the partners Citigroup(NYSE:C) and Bank of America Merrill Lynch (NYSE:BAC) are unfunded. Agreements with Barclays (NYSE:BCS) and Rabobank are fully-funded.
Who looks at the available Excel-files on ETFS’ website, which list the stocks used as collateral, will find some interesting stocks. The majority consists of small and mid caps. Furthermore there are a lot of illiquid Japanese stocks used as collateral. Also interesting is the statement regarding the valuation of the collateral on ETF Securities’ website, which says that the “collateral is highly diversified and/or of high quality”. Sure, Markowitzsays that diversification is important, but if the world stock markets tumble, the correlation between the equity markets approximates one. Keep the last paragraph in mind while you read the following example: The collateral with the highest weighting for the “ETFX DAX 2x Long” is the Spanish media company Promotora de Informacions S.A. (ES0171743117). Sure, it belongs to the EuroStoxxConsumer Services Index, but is it a good stock as collateral? Its price is EUR 1.38 with a market capitalisation of round about EUR 700 Mio. and a 52 week high of EUR 2.52 and a low of EUR 1.27. Thus the (nearly penny-) stock had a volatility of 47% over the last year (as of 24th June 2011). Some other collaterals used are small and more or less illiquid stocks from all over the world.
A positive aspect is that all of the ETFs are up to ten percent over-collateralised. In the example of the “ETFX DAX 2x Long” the fund is 9.14% over-collateralised. But imagine the above mentioned case of a default of the swap partner in falling equity markets and no other counterparty can be found to enter into the swap. The first possibility to switch to physical replication is hardly possible because of the highly differing collateral basket components. Furthermore physical replication is not possible in short or leveraged ETFs. Thus the last possibility is to terminate the fund and liquidate the collateral basket. But what kind of securities are in my portfolio? Right, mostly small and mid caps with a high beta and lower liquidity. It won’t be fun to liquidate this volatile portfolio in falling equity markets. So it is questionable if cushions of approximately 9% will be enough to sleep carefree.
French Connection – Lyxor, Amundi & Ossiam
The French ETF issuer Lyxor (Current AuM USD 55 bn.), uses its parent Societe Generale as swap partner. Other than ETF Securities, its ETFs are not that much over-collateralised. The very positive aspect comparing to Lyxor’scompetitor is that the securities in the collateral baskets are mostly large caps with a high market capitalisation. Furthermore Lyxor is very transparent regarding the collateralisation. Sometimes the transparency may lead to surprises. Investors should keep an eye on two things: First, the Lyxor ETF Euro Cash. Here one could clearly see the dominance of Spanish and Italian Government bonds. Perhaps, those collaterals should have been better banned from a money-market ETF since the expression “PIIGS” has become a common negative shortcut for the troubled Eurozone states. Second, in some ETFs appears a major collateral position called “UK Equity Holdings”. Obviously, this is a Lyxor AM associated fund vehicle. Hence it could be fairly risky for an investor to accept a security as collateral issued and managed by the ETF firm itself.
The cost-cutting approach of Amundi ETF (AuM USD 9.9 bn) seems to be what investors like. “We decided to implement a competitive pricing strategy. Cost is a key criteria when selecting an ETF; our TER is on average 25% lower than that of our competitors.” said Valérie Baudson, Managing Director of AmundiETF in an interview with ETF Radar. The issuer is a joint-venture between Societe Generale and Credit Agricole. Regarding transparency and quality of collaterals the newcomer makes a good shape. Detailed information about the underlying baskets is daily updated available via Amundi’s website – and no obscure securities (or strong overweight of French equities) appeared in three randomly selected samples. Amundi’s custodian is CACEIS Bank.
Ossiam, a brand new ETF issuer and affiliate of French banking-group Natixis, provides detailed and easy to find facts about the effective ETF holdings. Accordingly, one could quickly find detailed information about the specific securities. Obviously, Natixis wired some positions of their French equities portfolio to Ossiam because there is a clear dominance of major French stocks used as collateral. The French start-up uses State Street Bank Luxembourg S.A. as custodian.
Commendable Germans – Deutsche Bank and…
Another issuer to highlight is db x-trackers, who offers currently 187 products and manages USD 52.6 billion. It uses its parents Deutsche Bank as swap partner. A very commendable aspect of db x-trackers ETFs is the transparency regarding its collaterals. For each ETF you can see detailed information of the collateral basket like the allocation of the asset class, country, sector, currency, rating, etc. Of course you can also download the list of the whole securities used as collateral on a daily basis. The ETFs are UCITS compliant and the collateral exists of high quality securities. The used stocks are in most instances blue chips. Unfortunately the ETFs are just – if at all – little over-collateralised. Sometimes they are even under-collateralised. Let’s assume the case that the counterparty in the swap agreement (Deutsche Bank) defaults on the example of the DAX ETF (LU0274211480). This ETF is backed by a collateral value of 99.46% as of June 21, 2011. Thus the fund is under-collateralised. When looking into its country and currency weightings, the US clearly dominates with nearly 29% of the holdings, followed by Japan (22%) and Germany (20%). About 38% of the collateral are denominated in Euro, 28% in USD and another 22% in JPY. 13% account in CHF.
So in the (more or less) unlikely case of a default of the counterparty Deutsche Bank AG, investors may receive the value of the stocks that are used as collateral rather than the value of the index. Although they invested in the German Stock Exchange Index the collateral portfolio would consist of only 38% Euro investments. This situation appears not just at db x-trackers. Many ETF providers use this method of portfolio optimisation in their collateral basket.
A similar picture at comstage, one of the emerging ETF brands in Europe. Commerzbank’s subsidiary has 94 products available which account totally to an AuM of USD 9.5 billion. According to Arne Scheehl, Sales Institutional Clients, the Frankfurt-based ETF issuer uses the swap desk of Commerzbank for all their products. The swap is overcollateralised at a minimum of 105%. The collateral baskets contain strictly German government bonds which are in custody of Clearstream Banking Frankfurt. “Both the carrier basket and the collateral are published on our website.” he explained. One of the largest NAV difference has the comstage ShortDAX ETF (LU0603940916). Its basket NAV is 92.53% in favour of the fund – or in other words, roughly 7.5% are at risk vs. the swap counterparty. This means if the swap counterpart (here: Commerzbank) would come into serious trouble, the swap collateral should be 107.5% or more in order to prevent a potential loss. „Investors don‘t have to worry. We adjust all collaterals on a daily basis.“ adds Arne Scheehl.
„Tricky Brits“ – Barclays and its ETNs
A prominent player in the global ETN business is Barclays Bank with its iPath subsidiary. Its main rivals in the ETN business are Morgan Stanley (NYSE:MS) and UBS. Unlike ETFs, ETNs are senior, unsecured, unsubordinated debt securities. In case of iPath ETNs, these securities are issued by Barclays Bank Plc. One of their best-known products is the iPath VIX ETN series – linked to selected S&P500 VIX Futures. Investors buying these ETNs are more or less entering into a kind of simple bet: Barclays will promise to pay the specific performance (i.e. index return of the S&P500 VIX Futures) and will promise to pay back the individual market value when investors are selling the ETN. An important detail: The investor’s money is not posted into a pledge account or a separated collateralized securities account. Barclays main concern is delivering the benchmark performance. They do this either through swaps or investing directly in futures. It depends on which asset classes they are investing in. Unlike the leveraged ETFs, these ETNs are not covered by the Investment Act of 1940. Instead they are covered by the Investment Act of 1933 so they are free to use derivatives. According to Barclays, they only do their swaps „withinvestment banks and other financial institutions with very high ratings“. In addition, their obligations come from their bank itself, which has a double AA rating, not from a sub-entity.
„American Idol“ – Invesco PowerShares
There are also some risks luring across the Atlantic ocean. The synthetic issues that are of some concern in the U.S. are leveraged ETFs and Exchange Traded Notes (ETNs). There are a few issuers in the U.S. that do offer synthetic ETFs. ProShares, Direxion, Rydex offer leveraged and/or inverse ETFs. Invesco PowerShares do it a different way: “In the U.S. across the entire line of 112 funds that we manage, PowerShares ETFs are either fully replicated or use a representative sampling methodology.“ said Ben Fulton, Invesco PowerShares managing director of global ETFs. The PowerShares QQQ (NASDAQ:QQQ) and four BLDRs ETFs managed by the Bank of New York Mellon generally use a replication methodology. The PowerShares DB currency & commodity suite of eleven ETFs managed by Deutsche Bank, hold futures contracts as opposed to swaps. Invesco PowerShares also markets the PowerShares DB line of twenty eight ETNs managed by Deutsche Bank which are unsecured debt obligations of Deutsche Bank AG, London. “Regarding the use of swap based or collateralized ETFs, our preference has always been to fully replicate a portfolio where possible,” said Fulton. „In European markets, PowerShares ETFsare all UCITS compliant and we use specific replication investment methodology for fifteen of the nineteen funds, and one fund uses representative sampling“. Total return index swaps are used withthree funds in an effort to providethe clients with improved tracking and lower costs.
Investors should ask the right questions
One issue that regulators are concerned with is that securities lending has the ability to cause more counterparty risk and more collateral risk for the investor. The counterpartyrisk appears if the borrower cannot give it back. The collateral risk comes into play if the collateral that the borrower used is worth less than the security. In the U.S., investors are partially protected by the Investment Company Act of 1940 which only allows one third of the fund to be lent. One firm of note is iShares which posted securities lending income on their recent annual report. All in all, investors – in North America, Europe and elsewhere in the world – should realize that also ETFscould be associated withsome hidden risks. But nevertheless an ETF is nowadays one of the most transparent, liquid and cost-efficient vehicle one could have in its portfolio. So we recommend every investor to have a closer look at the collateralization of swap-based ETFsdue to big differences between the competing providers. Probably the simple conclusion one should bear in mind is: Even with ETFs and ETPs – Don’t let yourself be fooled.
ABOUT ETF RADAR MAGAZINE http://www.etf-radar.com/
Founded in Spring 2009, ETF Radar is a smart, private and independent organization which provides comprehensive market intelligence, news and fundamental research solutions strongly focussed on the exchange traded funds business. We are covering the ETF market globally and have launched the first global, high-end exchange traded funds magazine and will introducing new services within the next time in order to refine our value proposition. With our well established flag-ship publication, the ETF Radar Magazine, we strive to inform, inspire and educate investors around the globe. We are open-minded for new ideas and additional value-adding partners for our venture.
Global Approach, Local Insight: Our organization is structured into two regional hubs: Naples (Florida), which covers the Americas, London (UK) and Zurich (Switzerland), from where we take care of Europe, the Middle East and the Asia-Pacific region.
All-Star Cast Of Investment Experts: We recognize that delivering excellent performance depends on diversity of people and perspectives. Hence ETF Radar strives to attract, nurture and retain fellows which are talented and diverse. We are proud of a strong, quality oriented and international minded culture that exists within our organization. Based on this approach we are able to maintain a pool of excellent trained professionals with a deep understanding of the global financial markets and reliable expertise in the investment business. This are the people behind our well regarded, reliable and extraordinary views on the global financial markets – and the Exchange Traded Funds business worldwide.
+1 239 384 6090
Europe, Middle East & Asia-Pacific
+44 203 519 1179