InvestmentsMar 23 2012

ETFs: Replication challenge

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Most exchange traded funds (ETFs) are designed to deliver to the investor what industry practitioners often refer to as beta – that is, market risk and market reward.

To achieve this, a number of replication techniques have emerged, each of which has different implications in terms of tracking performance and underlying counterparty or operational risks. The two main types typically described are direct, physical replication and indirect, swap-based, often also referred to as synthetic – replication.

This unofficial classification system is not fully informative, however. To better understand how ETFs work it is necessary to subdivide these categories further:

• Full direct physical replication;

• Partial physical replication with stratified sampling;

• Partial physical replication with optimisation;

• Funded swap based ETFs; and

• Unfunded swap based ETFs.

Full, direct physical replication involves buying and managing all the underlying constituent securities of the index being tracked.

Managers of these ETFs have to dynamically trade their portfolio to keep up with changes to the index, so transaction costs can impact tracking performance. Partly to mitigate this, providers often engage in securities lending, which involves lending out the physical securities held by the ETF.

This exposes the ETF to counterparty risk that the borrower of the securities will default and the ETF will suffer a loss. To limit this risk, the ETF lender demands that the borrower deposits collateral with a third party custodian bank.

The idea behind this is that, if the counterparty fails, the collateral is liquidated in compensation to the fund.

Full physical replication can become difficult and/or expensive to implement when tracking broad indices that reference a high number of individual securities or when all or some of the underlying securities being tracked are relatively illiquid.

To overcome these problems, physical replication providers have developed tracking methods that involve only holding a portion of the underlying securities of the index. One method is called stratified sampling, and it involves the ETF provider holding a selection of representative securities only.

This could entail splitting the index into, for example, sector based subgroups, and then purchasing a sample of securities from each group. The choice of which securities will form part of the sample may be taken by the ETF manager or by a computer driven, quantitative model.

The main advantage of this approach is reduced costs to the fund. But it can also increase the possibility of the fund experiencing relatively significant tracking difference vis à vis the underlying index.

For example, the ETF could have an unintentional bias towards holding large cap stocks as part of the sample, which means that, if small cap stocks outperform, the fund will fail to reflect the true performance of the broader index that it is aiming to track.

Also, market exposure in a physical replication ETF using stratified sampling will not be as diversified as the actual index itself.

The other method is called optimisation. Again, this involves only holding some of the underlying constituents of the index being tracked. The difference with stratified sampling is that optimisation methods are entirely model driven, with a computer system making the buy and sell decisions.

The model might analyse historical data on a set of statistical factors – correlations between stocks could be one factor, for example – and from there create an optimal portfolio of securities that constitute a portion of the index being tracked.

Swap based replication

Swap based ETFs have been around since 2001. The premise of the swap based method is that, rather than the ETF itself dealing with the task of physical replication, this is instead handled by one or more investment banks, which are expert in providing exposure to indices.

Via a contractual agreement with the ETF – a swap agreement – it falls to the investment bank to deliver to the fund the exact index returns, before fees and replication costs, with the effect that the risks inherent to tracking are outsourced to a third party.

The advantage for the investor is precise tracking after fees and costs. Counterparty risk is also present with this arrangement, however. Physical ETFs that engage in securities lending create counterparty risk but then manage that risk by ensuring counterparts post other types of physical securities with an independent custodian.

In a similar way, swap based ETFs create counterparty exposure through their use of swap agreements, but then manage that exposure by ensuring that physical assets are held by an independent custodian for the benefit of the fund, should a counterpart default.

Swap based replication models can be further split into two main types: funded and unfunded. Funded swap based replication involves the purchase of a basket of securities from the swap counterparty - referred to as the substitute basket - with the latter committed to delivering the performance of the reference index in exchange for the performance of the securities held by the fund.

Another financial institution acting as independent custodian holds the substitute basket securities in a ring fenced account.

The substitute basket must comply with the European UCITS fund regulations on asset type and liquidity, and often - depending on the policies of the provider - will also comply with UCITS defined rules on diversification. The securities are held in a segregated account with a third party custodian where they are regularly independently monitored and verified.

Counterparty risk is measured as the swap market-to-market - the difference between the net asset value (NAV) of the ETF and the value of the substitute basket.

Under UCITS, swap exposure to a single counterparty cannot exceed 10% of the prevailing NAV of the ETF. This means that, in the event of a default by the swap counterparty, the investor could lose up to 10% of the NAV of the ETF at the time of default.

To manage this counterparty exposure the swaps will be reset if necessary to ensure that the ETF has no more than 10% exposure to the swap counterparty. But many ETF providers using this model set a more restrictive swap reset limit, further minimising the level of counterparty risk.

It is possible for securities lending to take place with this model, but many swap based ETF providers choose not to lend out the physical basket.

With the funded swap model, rather than purchase a portfolio of securities from the swap provider, the ETF instead delivers invested cash to the swap provider, which in return commits to delivering to the ETF the performance of the index being tracked.

At the same time, in order to ensure that the exposure of the ETF to the swap counterparty is kept within the UCITS counterparty exposure limits, the swap provider delivers a basket of securities as collateral to the custodian bank.

The collateral must be diversified in accordance with the Committee of European Securities Regulators (CESR) 2010 guidelines on collateral for derivatives, while some providers also apply other inhouse rules to ensure quality of collateral.

Margin requirements are applied to the collateral. The aim of such margin requirements is to ensure that the counterparty exposure is kept within necessary limits even if there was some decline in the value of the collateral.

The collateral is independently monitored, verified and market-to-market on a daily basis to ensure that the mathematical net counterparty risk exposure remains within UCITS requirements, although in many cases ETF providers will aim to reduce the swap counterparty exposure to zero.

No securities lending takes place at the fund level with this technique.

Underlying risks

All the replication techniques outlined above are used by ETF providers in Europe. All create underlying implicit counterparty, legal or structural risks that need to be effectively managed by the manager. However, these risks are not unique to ETFs – many mutual funds engage in securities lending, while many absolute return funds actively use derivatives as part of their investment policy.

A good starting point for objectively assessing underlying implicit risks is to look at how the product is regulated. In the case of European ETFs, most fall under the UCITS framework, which ensures that many of these risks are robustly controlled.

Beyond this, many providers put in place additional measures to further lower or control underlying implicit risks, such as reducing counterparty risk below UCITS thresholds, to provide further protection to investors.

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Manooj Mistry is UK head of Deutsche Bank’s ETF platform, db X-trackers.