You can fill yourself up with this free lunch

Even the most adventurous investor knows that, generally, there’s no such thing as a free lunch. However, I would suggest two exceptions. First, a well-diversified portfolio that delivers
better returns for less risk (although this lunch is often off the menu when markets crash). Second, Deutsche Bank’s db x-tracker DJ Eurostoxx 50 exchange traded fund (ETF).

You may be surprised by the latter selection. But it is free . . . sort of. This listed fund, which tracks European blue-chip stocks, is effectively being given away by its manager. I can almost hear the sceptical e-mails being typed right now, so let me explain.

Deutsche Bank quotes an annual management charge of 0 per cent on this ETF. It is able to do this because it tracks the index in a way that allows it to make extra money on the side. Here’s how.

Instead of holding a portfolio of shares that replicates the composition of the index, the db x-tracker ETFs use derivatives called index swaps. These are agreements to exchange the return on the securities held by the ETF manager for a return in line with a particular index.

Take the example of the db x-tracker Vietnam ETF – one of my favourite adventurous funds. If you download the annual report
from www.dbxtrackers.co.uk and look at the ETF’s holdings, you might expect to see a lot of shares in Vietnamese companies. In fact, there is not a single Vietnamese share in the list! Top holdings include Deutsche Post (5.4 per cent), Novartis (7.2 per cent) and Astra Zeneca (6.8 per cent). German companies account for 35 per cent of the fund and Swiss companies 33 per cent.

But before you ring up Trading Standards to complain, remember what’s going on here: Deutsche has structured the fund so that around 10 per cent of the money is used to buy a swap that promises to pay out the return of the Vietnam index, with the other 90 per cent held in those European shares as collateral.

Deutsche happens to have a lot of those European shares – so many that it is overcollateralised. It has provided more stock as security than it needs to, just to be on the safe side.

This brings me to the further twist. ETF providers that hold a lot of popular stocks can lend them out to other banks and hedge funds in return for a fee. This stock lending is common among big providers. Deutsche appears to have decided it can make so much money from it that it doesn’t need to charge an annual fee. Hence the free lunch I mentioned.

Crucially, these swaps-based ETFs deliver a return that is incredibly close to that of the underlying index – guaranteed by the swap provider. According to Deutsche’s accounts for 2008, the vast majority of its ETFs were within 0.1 and 0.3 per cent of the underlying index, a performance emulated by rival firm Lyxor which uses the same structure. Traditional ETFs that hold the actual shares in the index tend
to have wider tracking errors.

iShares’ emerging markets tracker, for example, had a tracking error of 1.25 per cent in the year to November 5.

Even so, some in the fund management industry have started fretting. They worry that private investors have no real idea that their money is being invested in derivatives and a basket of shares that bear no relation to what they think they are holding. Some also worry about the basket of collateral, and suggest that only the best security should be issued – namely government bonds rather than volatile shares (French bank BNP Paribas does this for some of its structures).

Then there’s the counterparty risk: that the party on the other side of the swap agreement doesn’t pay up.

So, should ETF providers use a range of counterparties (Source, the ETF provider backed by Goldman Sachs and Merrill Lynch does this), or just one? And what happens if the hedge fund to which the stocks are lent goes bust?

My point is that there’s nothing intrinsically wrong with any of this – but investors need to know what they’re buying into.

In my experience, the vast majority of advisers who use these funds don’t really understand the real risk of stock lending or counterparties. They just focus on the index being tracked and the total expense ratio.

So, by all means use a tracker ETF, but just remember what’s being tracked – and how much the free lunch costs.

adventurous@ft.com