John Fletcher, head of exchange-traded products at Charles Stanley, discusses the rise of swap-based ETFs and the implications for the industry
“When two tribes go to war, a point is all you can score,” apparently. Good old Frankie Goes To Hollywood. There are “two tribes” in the ETF sphere as well – one is the full replication tribe and the other is their swap based brethren. For a long time now the full replication tribal elders were saying that their products were best, because they were more transparent and easy to understand. Proponents have been saying they offer excellent tracking despite obvious shortfalls in how dividends or corporate actions affected performance and did not preclude certain clients from investing in their funds because of their complexity and structure.
iShares, the biggest ETF provider by far, with around 46% of total ETF assets under management (AUM) as at May 2010, have but only a handful of European swap-based funds in their selection of over 440 ETFs worldwide. However, it is widely believed iShares, having once been the flag bearer for full replication ETFs, is now moving towards embracing the swap culture used by so many of their peers. This isn’t necessarily bad news, but speaking personally, I for one would definitely miss the full replication ETFs if they were ever entirely replaced.
Why would I miss them? In my role as head of exchange traded products (ETP) at Charles Stanley, I very frequently get enquiries as to what ETFs can track, such an index, or how does an ETF work? Given the relative complexity of swap-based ETFs over their in specie cousins, it is much harder to explain how the derivative relationship works with swap-backed funds over fully replicated ETFs in the retail environment and, indeed, harder for the retail investor to understand in turn.
It boils down to a matter of transparency. Additionally, swap-backed ETFs introduce more counterparty risk into the mix with the possibility of default from the other side of the swap. Rules are in place under Ucits III to reduce the exposure to swaps in an ETF to just 10% of Net Asset Value (NAV). However if and when a default occurs, it would still be quite damaging to the ETF and to the reputation of the ETF provider as well.
What are swaps?
It would probably be a good idea at this stage to briefly explain what a swap is and how they are used in the ETF context. At its most basic, a swap is an agreement between two parties to swap future cash flows, and this is where the swap-backed ETF has an advantage over the full replication ETFs.
For example, swap-backed ETFs come into their own when the underlying index has a large amount of constituents, such as the MSCI World. One big issue with ETFs is their total expense ratio (TER). If a full replication ETF had to buy every constituent of an index, the ETF provider would find it very difficult to keep TERs low due to the complexity of running such an onerously large fund. With swap-backed ETFs this is not an issue, as the performance of one set of holdings, be it stocks, bonds or cash, is being substituted for the performance of the benchmark the ETF is following. Therefore, for example, one might have a selection of European equities whose performance is being substituted for the performance of the MSCI World index.
Why so many providers?
According to Blackrock’s most recent ETF Landscape Global Handbook, there were around 150 exchange-traded product (ETP) providers globally. With rules being introduced to prohibit banks engaging in proprietary trading – the Volcker rule – there are obvious synergies with some banks to introducing ETFs. For example, one benefit for a bank with swap-based ETFs is that a proportion of your market maker’s holdings, which is usually difficult to lend out, may well be used as part of a swap’s collateral instead. With politicians and regulators now clamping down on banks’ proprietary trading, an ETF might well now offer opportunities to hedge against unfavourable changes in the rules being implemented, through expanding the range of issues available to a client. Indeed, word on the grapevine is that a major US investment bank is looking into the possibility of an ETF launch in the near future.
Natural evolution, why swap?
Since the humble beginnings of ETFs back in the early 1990s with the introduction of the SPDR, ETFs have come a long way. As with anything manufactured by man, we will be forever looking to improve on the original. We now have ETFs that enable retail investors to trade markets which were traditionally only open to corporate clients because of their high cost barriers to entry. You can trade anything from pork bellies to inverse DAX ETFs with up to 300 times leverage.
As we move toward a bright future in the ETF investment space, the introduction of ever more complex or esoteric listings makes the issue of education on these products ever more pertinent. This in turn leads to a greater need for transparency with these products, otherwise a whole investment community might not understand what they are about and shy away from them. In a recent article written by yours truly, I theorised that in my opinion there were far too many ETFs and providers all offering a similar or same product, and that I hoped Darwinian ‘natural selection’ would see these numbers reduced naturally.
With recent theories about investment banks using them as a kind of hedge against unfavourable laws being introduced against their proprietary businesses, this might not now be feasible. If these banks adopt the swap-based model, which I think would be highly likely, is it the full replication ETF that will be extinct? I do hope not. As ETFs started in the 90s let’s finish as we started; in the immortal words of Frankie, “Relax, don’t do it”.
John has worked at Charles Stanley for seven years, managing investments for a range of private clients and small institutions. He trades equities, derivatives, ETFs and ETCs based on his own technical analysis.
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