Monthly Archives: July 2013

Risks inherent in ETF structures

Week 5: Understanding risks of real estate ETF strategies

Counterparty risk is most often forgotten by fund investors, however, it exists an investment vehicles that lend out the fund’s constituents (securities lending). This is not only the case for many mutual funds but also synthetic as well as in physical ETFs.  And the main providers of physical ETFs in Europe actually use securities lending.

Swaps in Synthetic ETFs

The use of swaps in form of total return swaps in synthetic ETFs causes additional counterparty risk in the structure of all synthetic ETFs. Because synthetic ETFs deliver the performance of the index they track via a swap contract normally with an investment bank as the counterparty whereby it exchanges the performance of such a basket for that of the index counterparty risk is intrinsic to their structure. This means that investors are irremediably exposed – at least theoretically – to the risk that the swap counterparty fails to deliver the performance of the index. While there may be multiple reasons why this may happen, the worst case scenario would be where the swap counterparty simply goes bankrupt. Irrespective of the cause, the ETF investor would be left with the contents of the “substitute basket” as collateral.

It is generally accepted that investors in synthetic ETFs are compensated for taking on swap counterparty risk with the reward of comparatively lower management fees, more accurate tracking vis-á-vis ETFs employing physical replication techniques or when actively managed it enables them to offer strategies such as multiple time the performance of an index.

Currency risk: Investors will most likely find a specific ETF offered in several currencies and different stock exchanges, which means there is no currency at that level. However, at the portfolio level the fund manager has to manage or hedge currency risk at the securities level when investing globally.

Risk mitigation

There are a series of regulatory measures that providers of synthetic ETFs must comply with as a means of protecting investors against this counterparty risk. Under UCITS rules, for example, the net counterparty risk exposure of an investment fund (i.e. not just ETFs) to any single issuer via a derivative (e.g. swap) cannot exceed 10% of its NAV. In effect this means that 90% of the ETF must be collateralised.

In reality though, the majority of synthetic ETF providers either fully or over collateralise their swap exposure on a voluntary basis, thereby increasing the level of protection afforded to investors. Furthermore, parallel to the voluntary enhancement of collateral requirements, providers of synthetic ETFs have also made major improvements in the area of transparency. For example, online disclosure – mostly on a daily basis – of the composition of the “substitute baskets” has become the norm. This level of transparency helps investors in synthetic ETFs to properly assess risk.

Securities Lending in Physical ETFs

Securities lending is the process of loaning assets to a third party in exchange for a fee. Some, though not all, providers of physically replicated ETFs have securities lending programmes in place with the objective of generating revenues that might partially, or in some cases completely, offset management fees and other sources of index tracking difference. Counterparty risk in this context arises from the fact that the borrowers of these assets might not return them to the ETF manager.

It is important to underline that, unlike the use of swaps for synthetic ETFs, securities lending is not a necessary practice for physical ETFs to deliver the performance of the index they track. Rather, the aim of a securities lending programme is to improve the ETF’s tracking performance. As such, exposing investors to the counterparty risk arising from securities lending becomes a matter of choice by ETF providers.

The level of disclosure around securities lending practices by providers of physical ETFs has improved substantially over the past couple of years. Some may argue it is not yet optimal. However, compared to the secrecy surrounding these practices in the actively-managed mutual fund industry, ETF providers can be fairly described as an “open book”.

In terms of protective measures, it has become common practice for providers of physical ETFs that engage in securities lending to either fully or over collateralise the loans. It is also important to note that while there is no regulatory limit to the amount a fund can lend out, some ETF providers have voluntarily adopted maximum on-loan limits. Some also offer indemnification (i.e. insurance) against potential losses.

Next week 6: Performance ratios

Real estate ETFs with largest discounts? Highest fees?

Week 4: The real estate ETF investment universe

The current analysis includes a total 47 real estate ETFs, which are being tracked in terms of their monthly performance, fees, yield and AUM.

After taking over the management of the Ishare universe Blackrock is by far the largest real estate ETF fund manager by number of funds with a market share of c38%, however by AUM Vanguard has a market share of 41% compared to Blackrock (35%). Although Vanguard does not offer many real estate ETFs it is managing the currently largest real estate ETF, which has a market share of 40% alone.

Figure: Fund Universe by Fund Manager


Source: Various, N. Lux, 2013

Most real estate ETFs are listed in the United States (c84%) and another c14% in Europe. As expected, also 68% of the funds have the U.S as their investment target, followed by 27% which focus on global strategies. Only 4% of strategies focus on Europe as an investment market.

Figure: Universe by investment target


Source: Various, N. Lux, 2013

Until now, 98% of real estate ETFs offered, follow a passive replication strategy. Most popular indices are subindices of the FTSE NAREIT or EPRA universe.

Figure: 10 Largest real estate ETFs



Fees are dependent on the fund manager and the investment strategy. Some smaller fund managers might not be as competitive in fees as larger ones. On average management fees are 46bps, with the majority being offered between 40-50bps. Within the same fund manager, the most popular fund will be offered at the lowest fees, while they might increase for certain other strategies. For example global strategies are typically priced slightly higher at 50-60bps.

Figure: 5 most expensive ETFs


Premium/Discount to NAV

ETFs typically trade very close to their NAV. Most real estate ETFs will be trading at a slight discount of 1-20bps. There are currently only 4 real estate ETFs which are trading at a premium.

Figure: 10 largest discounts


While the premium/discount for property shares is often an indicator of company size and liquidity, there is no correlation between ETF fund size and its discount/premium pricing. ETFs with the lowest discounts typically have their primary listing on the NYSE and have their investment benchmark focused on the United States. The few funds currently listed on the LSE appear to have the largest discounts.

Week 5: Performance & standard deviation

What about real estate ETF investment strategies?

There are a number of strategies used by ETFs that are not available to other real estate fund managers, which provide the ETF with more flexibility to react to market changes. ETF fund managers can follow a very passive strategy, these funds track an index, but funds can also be actively managed. There is no limit as to how actively they can manage the portfolio to focus on alpha strategies.

Figure: alpha-beta strategies road map

Source: Deutsche Bank, 2012
For example the majority of real estate ETFs are passive investments, meaning they track a benchmark index. Examples for passive beta strategies are:

  • iShares FTSE EPRA/NAREIT Asia Property Yield Fund
  • iShares FTSE EPRA/NAREIT Developed Markets Property Yield Fund
  • iShares FTSE EPRA/NAREIT UK Property

Few funds use a different approach than market capitalisation, considered smart or adjusted beta such as

  • BMO Equal Weight REITs Index ETF (ZRE-TSX)
  • PowerShares KBW Premium Yield Equity REIT Portfolio

There is currently only one true active fund, which differs in the asset allocation approach:

  • PowerShares Active U.S. Real Estate Fund

Invesco’s PowerShares Active US fund uses quantitative and statistical metrics to identify attractively priced securities and manage risk.
Physical ETFs can use the full spectrum of asset allocation tools for increasing or decreasing exposure to a specific style, sector or capitalisation

  • Sector rotation strategies
  • Arbitrage strategies
  • Hedging and defensive strategies
  • Stock-lending revenue strategies (from short sellers)
  • Market neutral strategies
  • Maintaining exposure during a manage transition
  • Hedging tools for shorting
  • Transition management

Being able to sell stocks shorts, provides the ETFs with downside protection in a crisis.

Synthetic ETFs

on the other hand are not based on stocks directly. They deliver the performance of the index they track via a swap contract. This technique allows them to have a smaller tracking error than conventional funds. The ETF manager builds a so-called “substitute basket” – sometimes also called “collateral basket” – these are assets of good credit quality delivering a low but risk-free return. In addition he enters into a swap contract with a counterparty – normally an investment bank – whereby it exchanges the performance of such a basket for that of the index.


Not all ETF’s are based on stocks. Some are based on derivatives, such as options and futures. For example commodity ETFs use futures to replicate the performance. The use of derivatives allows leveraging to do a multiple of what the market index does. Leveraged ETF’s seek to make 2 or 3 times the return of their target index, while leveraged inverse ETF’s seek to earn a multiple when the target index declines.
While these types of ETFs are much more common for commodities, there are currently only a couple of real estate ETFs using leveraged performance. Two noteworthy examples are applying a beta multiplied strategy are:

  1. Direxion Real Estate Bull 3X – Triple-Leveraged ETF
  2. Direxion Real Estate Bear 3X – Triple-Leveraged ETF

These funds deliver 300% (3x) of a selected benchmark index. They create short positions by investing at least 80% of their assets in derivatives: such as futures contracts; options on securities, indices and futures contracts; equity caps, floors and collars; swap agreements; forward contracts; short positions; reverse repurchase agreements (REPO); exchange-traded funds (“ETFs”); and other financial instruments that, in combination, provide leveraged and unleveraged exposure to selected index. The remaining is typically invested in short-term debt instruments that have terms-to-maturity of less than 397 days and exhibit high quality credit profiles, including government securities and repurchase agreements.
Leveraged ETF’s are generally used for short-term trades — not as long-term investments, since markets go up and down, so gains and losses are both amplified.
The largest provider of physical real estate ETFs is Blackrock through it’s ishare brand. Main stock exchanges are NY, London and Canada.
Figure: Fund manager and number of funds


Source: Nicole Lux

Next week: AUM, how large is the investment universe, what about performance?