There’s more to selecting an ETF than picking an index

Many investors in the GCC believe that the main decisions when choosing an ETF are picking the index to track and then selecting an ETF to match. However, there is much more to selecting an ETF, as these products now vary greatly in their structure and the total cost of ownership. Even S&P500 ETFs differ widely in their construction.

One of the key choices that investors face when selecting between ETFs is structure - physical or swap-based – and we will look at it in more details further in this article. 

All exchange-traded funds (ETFs) are designed to mirror the returns of a benchmark index. The simplest and most transparent are physical-based funds. They hold all or some of the underlying assets of the index whether they are stocks, bonds, or even gold bars.

In case of such benchmarks as the S&P 500, where underlying stocks are very liquid the fund manager can buy all the index securities in the fund, as a result the ETF is fully replicating the index.

Sometimes it is not possible to invest in all securities of the index, especially when an index contains a large number of constituents (for example Barclays Capital Euro Aggregate Bond index which has 3,200 bonds) or tracks illiquid securities (for example MSCI Emerging Markets), which makes full replication costly and inefficient. In these cases, the ETF may hold a representative sample of the securities from the index, and will be called sampled, or optimized.

With physical based ETFs (either fully replicated or sampled / optimized) the investor gets full portfolio transparency – investors can see the exact holdings within the ETF on a regular basis – downloadable at the ETF provider’s website. It is also important to note that the fund assets are held at a custodian in a ring-fenced segregated account for the benefit and security of the ETF unit holders.

The second mentioned type of ETFs are swap-based funds.  They are significantly different from physical-based funds in their structure and also used differently by various ETF providers. Some providers utilize swaps as an alternative to physical-based funds independently of exposures while others – only for difficult to access markets which are impossible to track with physical-based funds otherwise (i.e futures-based commodity indices, frontier and some emerging market countries indices etc).

Swap-based ETF structures raise some interesting questions in the investment society: Are swap-based ETFs a form of structured products? Are they suitable for all clients? Are providers transparent about the structure and risks these products employ?

Swap-based ETFs use swap agreements between the ETF provider and the swap counterparty (an investment bank) in order to replicate returns of desirable markets. In these ETFs, the fund holds a basket of securities (called the reference basket) that may be completely unrelated to the index that the ETF tracks. At the same time the fund enters into a swap agreement with the swap counterparty, who promises to deliver the performance of the index less swap fees to the fund.  In exchange, the fund delivers the return of the reference basket to the swap counterparty.

The value of the swap is assessed (or marked to market) on a daily basis and counterparty exposure is limited to 10% of the Fund’s Net Asset Value (NAV) by the UCITS rules .  This means that as soon as the difference in value between the reference basket and ETF NAV approaches 10%, the swap is “reset” and the swap counterparty pays the difference into the ETF.

One might wonder what happens if the swap counterparty fails? Well, in that case ETF investors will receive either holdings of the reference basket or proceeds from the sale of those holdings in proportion to the respective ownership in the ETF. This puts a significant emphasis on the quality and liquidity of the constituents in the reference basket that - should the fund need to close – investor will be left with. The experience of the ETF manager, its track record and the reputation are additional points which investor should carefully assess and consider when looking at swap-based ETFs.

Various ETF structures can benefit different investors depending on their requirements however, investors should be aware of these differences and the risks and implications they may carry. Investment professionals in the Middle East have used physical-based ETFs for years, and there are a growing number of institutional investors in the GCC that are now comfortable using swap-based ETFs. I fully expect growth and maturation of both types of ETFs in the region in the coming years.

I would encourage all investors and investment advisors who are considering investing in ETFs to first read the specific ETF prospectuses, which should outline the structures used to manage selected funds. And to go a step further: please contact the ETF managers directly to get more details about the various structures used in managing ETFs.

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