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Multi-manager view

There has been rapid growth recently in the number of exchange traded fund providers and the range of products offered. Broadly speaking, the leading providers have an asset size of at least $5bn and a reasonable range, at least 50 ETFs each. However, the market is very concentrated at the top – iShares has assets of over $100bn followed by db X-trackers and Lyxor at around $40bn, with the next biggest competitor being around $20bn.

The proliferation of products and providers and the methodologies used by each provider means it is essential to differentiate between ETFs.

Broadly, there are two main types of ETFs – physically invested and synthetic ETFs. Physically invested ETFs are plain vanilla products that aim to match an index return either by holding all the stocks in the underlying index or by holding a representative sample (typically preferred when full replication is deemed unfeasible, for example, if the index contains too many securities or many illiquid securities).

Synthetic ETFs are more complex – most seek to achieve the index return through swap agreements with third parties. This typically reduces the tracking error compared with physically invested ETFs that use a representative sample and can lead to lower overall total expense ratios. However, there are extra risks such as collateral mis-match and counter-party risk.

Given the complexity of synthetic ETFs, it is therefore very important to understand the underlying swap structures. With unfunded swaps, the ETF provider sells the ETF for cash and uses the money to buy a basket of securities. The return on these securities is then swapped for the index return (minus swap fees) with a third party. Critically, the fund holdings do not have to be of a similar liquidity to, or be correlated to, the reference index. Also, the value of the fund holdings does not have to equal the net asset value of the ETF. Under Ucits rules, the fund holdings must be equal to at least 90 per cent of the NAV of the ETF.

Funded swaps are arguably safer. The provider sells the ETF for cash and transfers the money to a swap counterparty in exchange for the index performance. The counter-party then posts collateral assets in a segregated account with a third-party custodian. The collateral is typically marked to market on a daily basis and is of equal or greater value than the NAV of the ETF. However, again, the securities held as collateral do not have to be of a similar liquidity to, or be correlated to, the reference index.

ETFs probably have two key uses in multi-asset portfolios. The first is in tactical asset allocation, where positions are shorter term in nature and ETFs represent an efficient means of accurately executing a desired position – they are easily tradable, relatively cost-effective and avoid the tracking error risk associated with using an active manager. The second is when cheap structural exposure to an asset class is required, either where active managers have historically struggled to match the market index after fees or in specialist markets where there is a lack of conviction, given the limited number of active managers.

If it was ever justified to lump ETFs together as “just index funds”, this time is long past and careful analysis is needed.

Hans Hamre is director of research at FundQuest


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