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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

Commercial real estate risk news

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