Do You Know What's In Your ETF?

Understanding physical replication versus synthetic replication as a means to tracking an index

Morningstar ETF Analysts 16 March, 2010 | 10:41AM
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The goal of passive investment products like exchange-traded funds (ETFs) is to replicate the returns of a benchmark index as closely as possible. For instance, an investor seeking diversified exposure to large-cap European companies may invest in the DJ Euro Stoxx 50 Index from a number of ETFs which track it, from major providers such as Lyxor and iShares. That's why many people refer to ETFs as 'index trackers'. While most ETFs share this same goal, they differ in how they do it; some use what's known as physical replication, while others do it through synthetic replication.

Physical replication ETFs are the more intuitive of the two main types of ETF. A 'full replication' physical ETF replicates the performance of an underlying index by simply purchasing all the securities covered by the index. The portfolio manager's task is then to mirror changes in the index composition, as well as to manage cash flows from interest and dividend payments. In cases where the underlying index includes illiquid securities, one-hundred percent duplication of the index is undesirable because of the increased costs involved. Instead, the portfolio manager will use optimisation strategies generally based on historical results to create a 'sampling' ETF, which tracks the index return as closely as possibly. However, because the optimisation strategy will not always be successful, 'tracking error,' the risk that the ETF's returns diverge from those of its index, may be greater with a 'sampling' ETF.

Synthetic, or swap-based, ETFs use a more complex structure to reduce 'tracking error', although they come with their own costs. Instead of holding the securities in the underlying index, a swap-based ETF holds a basket of securities as collateral to provide some safety for shareholders, and exchanges the performance of these securities with an investment bank counterparty for the performance of the reference index. Because the agreement calls for the ETF to receive the full return of the index from the counterparty, minus a fee, this structure reduces 'tracking error' as there should be little to no variation in the difference between the actual returns received and the index's return from year-to-year. However, this structure does introduce counterparty risk as fundholders rely on the investment bank for the promised returns, as well as to post collateral on a daily basis. Holders of physical ETFs are free from these concerns except when it comes to securities lending.

The risk of a counterparty failing to make good on its swap contracts due to financial distress has become a real concern in the past couple of years. Typically, the large banks that serve as counterparties are stable institutions, but the 2008 financial crisis proved that no company is immune to failure. The collateral that swap counterparties provide go a long way towards mitigating this risk, but it does not eliminate it completely, especially since there can be little transparency of what collateral the ETF actually holds on a daily basis. Because different providers have different policies for swap agreements it is very important that investors research the particulars when looking at ETFs. For instance, while UCITS (Undertakings for Collective Investments in Transferable Securities) III funds limit counterparty risk from swaps to 10%, most providers go even further to reduce risk by including overcollateralisation or multiple counterparties in their swap agreements. For more sophisticated investors, hedging is an option to reduce this risk by either buying CDS protection or out-of-the-money put options on the counterparty.

While ETF providers generally specialise in either one method or the other, they will often choose a particular method for certain asset classes. For instance, while ETF Securities funds are generally swap-based, the company's physical gold fund holds actual gold bullion stored in a vault. On the other hand, iShares is the predominant physical replication ETF provider throughout Europe, but the firm offers a number of funds that are swap-based such as the iShares Dow Jones-UBS Commodity Swap (DE), based in Germany, which follows the DJ-UBS Commodity Index Total Return.

So what should investors look at when deciding between a physical or swap-based ETF?
As always, fees are going to be one of the most important factors in that decision, as they tend to be the greatest drag between an ETF's return and the return on its index, for both physical and swap-based ETFs. Unfortunately, because the components of each type of ETFs' total expense ratio (TER) are different, it is not the case that one method has lower costs than the other under all circumstances. For instance, while swap-based ETFs have an additional swap fee, physical ETFs suffer from trading costs, so determining which fees are lower needs to be done on a case-by-case basis. Also, securities lending, often a significant source of additional income for an ETF, can complicate matters further. Both swap-based and physical ETFs can benefit from this income, but there is an additional barrier for the investor in a swap-based ETF as the swap counterparty agreement will determine how much of this income will be kept by the investment bank and how much will go to the ETF investor.

Tax issues also need to be taken into consideration. Different types of income like dividends, interest, and capital gains can have different tax implications, and so ETFs' returns can vary depending on their structure. This is where one of the greatest advantages of swap-based ETFs comes into play as it eliminates the 'tracking error' from dividend withholdings taxes. As always, you may need to consult a tax professional to sort out the issues involved.

Liquidity is another issue that can affect ETFs depending on their structure. While physical ETFs have multiple authorised participants who can create and redeem shares, a swap-based ETF is limited to only the swap counterparty. Theoretically, investors in physical ETFs benefit from tighter bid/ask spreads and greater volume as more market-makers are willing to compete for business from physical ETFs. In times of high market volatility, this may lead to more trading costs in swap-based ETFs.

Ultimately, there is no simple answer for investors looking to choose between physical and swap-based ETFs. For any particular index, one investor's needs could be better served with a physical ETF, while a different investor will prefer a swap-based ETF. Of more importance is taking into consideration fees, performance history, personal tax issues, liquidity and the balance between tracking and counterparty risk when weighing the pros and cons of each particular index tracking method.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.

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