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Guide to ETFs
Your IndustryOct 29 2015

How ETFs operate

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Most exchange-traded funds aim to track the performance of an index, whether that is an alternative, or a traditional market-cap-weighted index such as the S&P 500, Euro Stoxx 50 or FTSE 100.

The ETF issuer will try to ensure that the fund performs as closely as possible to the index itself.

There are several ways to achieve this, but there are two main types of replication methodology – physical and synthetic.

Physical replication is when the ETF holds all, or a majority of, the securities in an underlying index. Orders are typically fulfilled by exchanging baskets of securities for the ETF shares.

Typically managers using physical replication also use some additional portfolio management techniques (as do many fund managers), says Christopher Mellor, head of equity product management at Source.

They use these techniques, with the aim of either enhancing performance and/or reducing costs.

These techniques include stock lending, which as the name suggests is when the ETF issuer loans out some of the stock that the ETF owns, and collects interest on the loan until the stock is returned to the ETF.

This interest is used to enhance the returns of the ETF, but it does carry with it the risk that the debtor fails to pay the interest or return the stock.

Other variations on physical replication are outlined below.

Physical replication can be more costly, according to Vivian Tung, vice president for product strategy and Global ETF product at Brown Brothers Harriman, than the synthetic replication model.

Ms Tung says this is because this strategy incurs higher acquisition and trading costs.

The higher costs may impact performance and tracking to the underlying index, as well as the trading opportunity, as they have to pay a creation/redemption fee, which is generally made up of the cost to settle the physical basket trades.

Synthetic replication is typically achieved by the use of derivatives or swaps.

ETFs can enter into swap agreements with multiple counterparties to mimic the underlying index.

In addition, collateral and the management of collateral is required to back the swaps.

Orders are fulfilled by exchanging cash for ETF shares. This model can be less costly since there are less acquisition costs, says Ms Tung. However, she says a synthetic ETF does introduce counterparty risk.

“Despite the lower costs, regulations restricting the use of derivatives in funds have impacted the number of synthetic ETFs launched,” she stated.

Replication can also involve potential credit risk if the issuer engages in stock lending.

However Townsend Lansing, head of short/leveraged and FX platforms at ETF Securities, says these risks are mitigated through the provision of collateral and this factor should be accounted for in any product due diligence undertaken by investors.

Different types of ETPs

An exchange-traded fund is only a part - albeit the biggest part - of a broader family now commonly referred to as exchanged-traded products (ETPs).

Also falling under the broad ETP umbrella are exchange-traded commodities or currencies (ETCs) and exchange-traded notes (ETNs).

While the large majority of European-domiciled ETFs are Ucits-compliant instruments, Morningstar warns ETCs and ETNs are not.

Exchange-traded funds

Like traditional mutual funds, exchange-traded funds are highly regulated according to the European Ucits IV directive, which applies to all investment funds.

Ucits requirements provide a number of important safeguards for investors, including:

1) segregated assets to minimise risk in the event of bankruptcy of the provider;

2) increased transparency; and

3) diversification limits to protect investments becoming concentrated in a single asset.

The big difference from traditional mutual funds is that ETFs are listed on an exchange such as the London Stock Exchange.

As such, they provide advisers with intraday price transparency and the ability to buy or sell holdings as easily as trading a share.

Exchange-traded commodities

Exchange traded commodities, which are structured as debt securities that pay no interest, have emerged because the Ucits regulations mandate a minimum level of investment diversification and restrict the asset types that can be held by ETFs.

In Europe, the solution was to use a debt security issued by a special purpose vehicle (SPV) with segregated assets.

These vehicles are not restricted by the Ucits diversification requirements and can offer exposure to a single or small number of commodities.

The ETC legal structure has also been used to offer investors access to currencies, whether as individual currency pairs or a ‘currency basket’.

Exchange-traded notes

Like ETCs, ETNs are non-interest bearing debt securities that are designed to track the return of an underlying benchmark or asset.

They are generally issued by banks, hold no assets and, unlike the two exchange-traded alternatives, are not collateralised.

ETNs are similar to unsecured, listed bonds and as such are entirely reliant on the creditworthiness of the issuing entity.

A change in that creditworthiness might negatively impact the value of the ETN, irrespective of the performance of the underlying benchmark or asset.

In extreme circumstances, default by the issuer would leave the investor to claim as an unsecured creditor against the issuing entity.