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Replication strategies for exchange-traded funds

This article is part of
Guide to Exchange-Traded Products

Performance swaps

Mr Thompson says the other way that a fund manager can look to optimise the performance of their ETF is through the use of a performance swap contract.

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These ‘synthetic’ ETFs also invest in a basket of physical assets such as equities or bonds, which are owned directly by the fund and appear on the fund’s balance sheet.

However, Mr Thompson says this time the role of the physical assets is not to provide the performance of the fund, but purely to act as security. The performance of the fund is instead based on dervatives known as ‘performance swaps’.

This swap is a contractual agreement which is negotiated between two parties: the ETF and the swap counterparty. The swap counterparty commits to pay the precise daily performance of the benchmark index, including any dividends to the ETF.

In return, Mr Thompson says the ETF pays the swap counterparty a fee for the swap arrangement, and the performance of the physical assets it holds, including any dividends.

Mr Thompson says: “Using performance swaps or securities lending initiatives involves additional risk for investors.

“This risk may still be acceptable if it delivers sufficient additional returns; either through a performance improvement or a reduction in tracking error.

“If this is not the case, the best replication method would be a physical structure without any swap or securities lending.”

Assessing risk

While there is a general tendency to view physical replication as structurally ‘less risky’ than synthetic, Ben Seager-Scott, senior research analyst at Bestinvest, says this is not always the case and the arguments for and against different replication methods can be fairly nuanced.

For synthetic exposure, Mr Seager-Scott says it is important to note that in all of these cases exposure to counter-parties are limited where Ucits rules apply, and most groups will ensure counter-party risk is mitigated through collateralisation policies.

Since physical replication involves buying and selling index components, Hortense Bioy, director of passive funds research at Morningstar, says this strategy is inherently more labour intensive and potentially more costly than synthetic replication, depending on the market being tracked.

Ms Bioy says: “ETFs using physical replication may also exhibit larger tracking error than ETFs using synthetic replication.”

In order to mitigate the risks of the existing swap-based ETF structures, a spokesman for iShares says various ETF providers started launching new swap-based ETFs which would tackle some or all of the flaws of the swap-based funds.

The spokesman says: “Multi-counterparty swap models with an over collateralised counterparty exposure model mean that the aggregate market value of collateral taken will exceed the overall counterparty exposure.