Tracker funds share the risk around

Investors seeking to boost their profits from rises or falls in equity indices – but without some of the risks associated with spread bets and structured products – can now buy into a new range of exchange traded funds (ETFs).

This week, ETF Securities launched the first “double-leveraged” tracker funds to be backed by multiple counterparties, rather than a single bank, and hold collateral in excess of regulatory minimum.

These ETFs generate returns equivalent to two times the rise, or two times the fall, in the FTSE 100, Dax or Dow Jones – by tracking special double-leveraged or double-short versions of these three indices. For example, if the underlying index falls by 2 per cent in a day, the ETF tracking the two-times leveraged index will fall in price by 4 per cent, but the ETF tracking the two-times short index will rise in price by 4 per cent – and vice versa.

So, in effect, the new funds allow private investors to gain long or short exposure to the UK, US and German stock markets, and try to profit from moves in either direction.

Like a number of equity ETFs, these newly-listed funds from ETF Securities rely on instruments called index swaps, issued by counterparty banks, to produce returns in line with the stock market indices. But, unlike existing ETFs, each of the double-leveraged funds will use index swaps issued by up to six different banks to minimise the risk of one counterparty going bust.

This risk was highlighted last year when ETF Securities’ commodity trackers were hit by the near collapse of their single counterparty, AIG, and a number of structured products lost money following the bankruptcy of Lehman Brothers.

In addition, collateral to the value of more than 90 per cent of the counterparty exposure – the minimum required under the Ucits III regulations – will be held. This will allow ETF Securities to close out an index swap position with any bank in difficulty, and re-open one with another counterparty.

According to the company, these “third generation” ETFs have been designed in response to “investor demands for increased levels of transparency, liquidity and counterparty-risk management”. It believes their listed fund status will also appeal to investors who do not wish to be exposed to unlimited losses on spread bets.

“From a risk point of view, it’s more robust than the single bank swap model,” said Hector MacNeil, head of sales and marketing at ETF Securities. “And, under the multiple swap model, up to six banks will be providing liquidity.”

However, other ETF providers suggest that the additional cost and complication of using multiple counterparties for a simple index tracker may deter investors.

Db x-trackers offers unleveraged long and short ETFs on the FTSE 100 and a selection of US, European and Asian indices, and believes that using its parent , Deutsche Bank, as the index swap counterparty provides reassurance, while keeping charges down.

“ETFs are low-cost products and you want to make sure costs are as low as possible,” said Manooj Mistry, head of UK ETFs. “When you introduce complexity and multiple counterparties, the cost aspect has to be absorbed by providers or passed on to investors.” Db x-trackers’ FTSE 100 Short ETF has an annual fee of 0.5 per cent while ETF Securities’ FTSE 100 Super Short Strategy (2x) ETF has a total expense ratio of 0.6 per cent. Mistry added that the db x-trackers’ ETFs are “between 95 and 100 per cent collateralised at all times”.

Lyxor also prefers to use its parent bank, SocGen, as the counterparty for the index swaps on its ETFs. It does not offer short or leveraged funds, but has some of the lowest annual charges for conventional long ETFs, ranging from 0.3 per cent on its FTSE 100 ETF to 0.65 per cent for its MSCI Emerging Markets tracker.