An ABC of ETFs

Exchange traded funds (ETFs) are considered to be straightforward, low-cost index-tracking investments. But private investors have been advised to check how they track an index – as not all ETFs are as transparent as they seem.

Until recently, almost all ETFs in the UK were “physical-based”, and aimed to achieve “replication” of an index – meaning that the ETF provider bought the shares in the index that it tracked. iShares, the first ETF provider in the UK, still offers mainly physical-based ETFs.

But more recent entrants have been issuing “swap-based” ETFs. These do not physically hold the shares in an index, but instead use derivatives called index swaps. Swaps are contracts – usually with an investment bank – to exchange one set of cash flows for another. The investment bank has to pay the return from the index to the ETF provider, which effectively outsources the index tracking to the investment bank.

This can reduce tracking error – but it has one major drawback: it can introduce counterparty risk. The ETF becomes dependent on the bank, as counterparty to the swap, to deliver on its promise. ETFs are bound by rules that limit this risk to 10 per cent of the value of the fund, meaning 90 per cent of the fund’s value has to be held in physical collateral.

Even so, with private investors now wary of this risk, following the collapse of Lehman Brothers last year, some swap-based ETF providers have taken steps to eliminate counterparty risk altogether.

Db x-trackers, owned by Deutsche Bank, now has between 100-110 per cent of the value of each of its swap-based ETFs in physical holdings, up from 95 per cent a year ago. So, while some of the fund is still used in swaps with Deutsche Bank, the actual counterparty risk is removed.

“We felt we should eliminate concerns people might have and give them reassurance,” says Manooj Mistry at db x-trackers. He added that costs are not passed on to consumers but borne by Deutsche Bank.

Swap-based ETFs can charge less as they make extra money by lending out their holdings. They can also have lower tracking errors as they are not reliant on accurate replication of an index.

Tracking errors can be a problem for physical ETFs, as replicating index performance is difficult. Some physical ETFs try to offer full replication, buying every stock in an index such as the FTSE 100. Others merely sample an index, to save on time and costs – for example, the MSCI World Index comprises more than 1,700 stocks, meaning that full replication of the index would be too costly in terms of dealing charges. But the disadvantage of the sampling route is that it can lead to tracking errors.

Swap-based funds will theoretically track an index more efficiently – but Ben Yearsley at Hargreaves Lansdown argues that, as many have only been around for less than five years, it is difficult to form a complete picture of their performance record.

As a result, some advisers prefer to use swap-based ETFs only in certain markets, and rely on physical-based ETFs in others.

Paul Willans, a partner at Mazars, the financial planners, believes that physical-based ETFs make more sense in stable markets. When the companies making up the index do not change very often, physical-based ETFs can keep their costs down as their transactional costs will be low.

But swap-based funds can be more nimble. “During volatile markets, swap-based ETFs may be more attractive,” says Willans.

Even so, the more complex structure of swap-based ETFs still puts some investors off. “I prefer buying an ETF that’s slightly more cost-inefficient but where you know what you’ve got,” says Tom Becket at PSigma.

Swap-based ETFs, however, are not necessarily riskier than physical-based funds. “It’s a different type of risk,” says Mick Gilligan, an analyst at Killik. He points out that while swap-based funds may carry counterparty risk, physical funds have more risk of tracking error.

ETF Q&A

What is an ETF?

An ETF is an exchange traded fund – a fund of assets that aims to track the performance of an index, but which can be bought and sold like a share, via a stockbroker.

I don’t have any ETFs. Should I get one?

ETFs are cheaper than other managed funds, such as unit trusts and investment trusts. So they can be an efficient way of gaining exposure to main asset classes as well as balancing portfolios – they track not only equities but also bonds and commodities, single countries and sectors. However, by definition, ETFs cannot outperform their indices. So, if you believe a manager can deliver outperformance, you should buy an actively-managed fund.

Can I pop one in my pension?

Yes. ETFs listed on the London Stock Exchange can be put into self-invested personal pensions (Sipps), individual savings accounts (Isas), offshore bonds and child trust funds.

Are all ETFs the same?

No. There are two types of ETF: physical ETFs and swap-based ETFs. Physical ETFs hold shares in the index they are tracking. Swap-based ETFs use derivatives called index swaps: agreements to exchange the return on securities held by the ETF manager for a return in line with a particular index. iShares and Invesco offer physical ETFs, while db x-trackers, ETF Securities and Lyxor offer swap-based funds.

Could I lose all my money in an ETF?

An ETF tracks an index, so you could lose as much as the index – which, in a bear market, could mean half your original investment or more. If you buy a swap-based ETF, there’s also counterparty risk to bear in mind – though this is limited to 10 per cent of the fund.