Tag Archives: ETF

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

Week 2: Understanding real estate ETF structures

In the previous session we have established that ETFs are in principal open-ended investment companies, whose shares can be traded on the stock exchange. (for a list of real estate ETFs traded on LSE download FTSE ETF)
In general investors are seeking diversified returns when they are looking to invest in a mutual fund such as a real estate securities fund. Investing in a mutual fund provides investors with exposure to a portfolio of assets in a specific sector or region.
Since 2000 a new style of mutual fund has entered the European market, the so-called exchange traded funds (ETF). Compared to a mutual fund they offer the following advantages:

  • they have a higher liquidity and can be traded on a stock exchange just like any other share. Thus, they are yet another product that offers real estate exposure on a highly liquid basis for an otherwise illiquid asset class
  • Accessible to retail investors, require smaller initial investment amounts
  • Lower cost, typically no initial fees

However, in some other aspects they are more similar to Property Unit Trusts (PUTs) than real estate securities funds.
Any investor who has mastered the understanding of Property Unit Trusts, will see the similarities and find the ETF structure easy to understand.
Just like the PUT, the ETF issues or creates units based on the NAV of the underlying portfolio. The difference is that the shares of an ETF can be traded throughout the day on the exchange and the portfolio does not consist of physical properties but shares of property companies or REITs.
Figure: Physical ETFs
physical
Source: N. Lux, 2013
This also means that the price of an ETF share on the stock exchange is subject to the forces of supply and demand and the trading price can be different to the fund’s NAV.
When the ETF creates new units it issues bundles of shares, which  are being bought by the “authorised participant”. This participant can be a market maker, broker, large institutional investor etc, who is then trading individual shares on the stock exchange.
Because the trading price does not completely reflect the NAV, ETFs behave more like an individual share than a mutual fund, which is investing in property company/REIT shares. However, ETFs have different liquidity levels themselves and the more liquid ETFs are expected to trade very close to their NAV.
Table: Example trading price vs NAV
Example
Also for mutual funds there are differences in pricing, for example an open-ended fund (i.e. PUT) will trade equal to its NAV while a closed-end fund can trade at a premium or discount (discounts are expected to be larger than for ETFs).

Portfolio setup and strategies

The ETF itself originates with a sponsor, meaning the company or financial institution which chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways.
1. A replicate index-based ETF holds every security in the target index and invests its assets proportionately in all the securities in the target index.
2. A sample index-based ETF does not hold every security in the target index; instead, the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities.

Target indices include:

US Indices

  • Cohen & Steers Realty Majors Index
  • Dow Jones U.S. Real Estate Index
  • Dow Jones U.S. Select REIT Index
  • FTSE EPRA/NAREIT North America Index
  • FTSE NAREIT All Mortgage Capped Index
  • FTSE NAREIT All Residential Capped Index
  • FTSE NAREIT Industrial/Office Capped Index
  • FTSE NAREIT Real Estate 50 Index
  • FTSE NAREIT Retail Capped Index
  • IQ US Real Estate Small Cap Index
  • KBW Premium Yield Equity REIT Index
  • Market Vectors Global Mortgage REITs Index
  • MSCI US REIT Index
  • S&P United States REIT Index
  • Wilshire U.S. Real Estate Investment Trust Index
  • Morningstar Real Estate Index

Other Indices

  • FTSE EPRA/NAREIT Developed Europe ex UK Dividend+
  • FTSE EPRA/NAREIT UK Index
  • FTSE EPRA/NAREIT Developed Asia Dividend+ Index

Both of these replication methodologies are called physical ETFs. In addition to the physical ETF there are so-called “synthetic” ETFs, which deliver the index performance via a swap contract. The total return will then be delivered by the swap contract, while the cash in mainly invested in low risk collateral such as zero coupon bonds, which were acquired at a discount or government bonds.
Figure: Synthetic ETF
synthetic

Source: N. Lux, 2013
Real Estate ETFs are currently mostly physical ETFs, meaning they invest in a basket of physical securities. We will analyse the different risks related to these strategies in the next session.

Downloand PDF Property ETFs week 2

Next week 3: Understanding the risks of ETF Structures vs real estate REIT funds