A Swap-Based ETF Checklist
Written by Paul Amery - November 08, 2010 20:17
In Europe, exchange-traded funds using derivatives to track their underlying index now outnumber those using traditional, physical replication by around two to one. However, a close examination of swap-based ETF structures reveals some significant differences, notably regarding collateral policy, swap reset frequency, swap fees and the taxation of dividend income from the underlying securities.
We have therefore put together a checklist that investors can use when evaluating and comparing exchange-traded funds from different providers.
1. Who’s The Counterparty?
The swap counterparty exists to guarantee ETF investors their index return (after fees). Assessing the direct credit risk of swap counterparties is relatively straightforward, even if obtaining the relevant information may require some legwork if you don’t have a Bloomberg subscription.
For example, investors can refer to the credit default swap spreads of the swap-writing banks for an indication of both absolute and relative credit risk. Banks’ asset swap spreads are an alternative measure (asset swap spreads show the price of credit for a bond issuer, expressed as a margin over the wholesale interest rate).
Swap-based ETFs may have single or multiple counterparties. In the case of the multiple counterparty swap-based ETF structure (as offered by issuers Source, ETF Exchange, and in iShares’ latest swap-based funds), rules exist both to ensure diversification between counterparties and for counterparty replacement if one fails to perform its duties. But ETF issuers using the single swap provider model argue that they can internalise certain costs and ultimately provide investors with a better deal (see point 4 below).
2. What’s The Collateral Policy?
Europe’s UCITS rules, which set the risk management policy to be followed by almost all the region’s ETFs, specify that net exposure to derivatives counterparties may not exceed 10% of a fund’s net asset value.
Collateral is therefore used to reduce ETFs’ exposure to their swap counterparties.
How collateral policy is enforced within the overall UCITS framework is down to the individual regulator in the country where the fund is domiciled. For most swap-based ETFs, this means Ireland or Luxembourg, though there are also swap-based ETFs resident in both France and Germany. In practice, differences in domicile can lead to some differences in the actual rules set.
The Irish financial regulator, for example, did not allow equities as collateral for swap-based ETFs until early this year. When it did, it insisted that equities be subject to a 20% “haircut” (in other words, collateral held in the form of equities should represent at least 120% of the counterparty risk exposure). In Luxembourg, where equities have been permitted as collateral in derivatives-based UCITS (like ETFs) for longer, it’s up to the fund custodian, the fund management company and the fund’s directors to set any haircut for equity collateral.
The reset policy for the swaps backing a fund can also have an effect on the overall level of collateralisation. Some ETF providers reset their swaps only quarterly, others according to a more frequent schedule, including daily. The minimum level of collateralisation required to trigger a swap reset can vary from the UCITS-prescribed minimum of 90% to 95-97% in some cases, while the level of collateralisation reached after a reset can also vary, from under 100% to 120%.
The overall level of collateralisation reached as a result of all these considerations can, in turn, also reflect differences in a swap-based ETF’s structure (see point 3 below).
If you imagine liquidating a swap-based ETF’s collateral after an insolvency event, the actual make-up of the basket of securities may impact your ability to do so. A collateral basket containing Japanese equities will require you to wait until Asian trading hours to get best execution on a sale, for example.
Owning bonds as collateral may sound safer in theory than owning equities, but is it in practice? If your bond collateral performs differently to the index you’re tracking, you’re exposed to correlation risk.
Two swap-based ETF issuers, Credit Suisse and iShares, now disclose their funds’ collateral baskets daily on their websites. Other providers offer this information only at six-monthly intervals (in their funds’ annual and semi-annual accounts) or on request.
More frequent disclosure is undoubtedly better from an investor’s perspective, if only as a form of reassurance that good quality assets are being held to back the swap counterparty’s promises.
3. Owned Assets Or Prepaid Swap?
Can the structure adopted by the swap-based ETF affect the security of an investor’s interest in a fund? There’s a difference between two groups of European ETFs that’s worth being aware of, say some fund providers.
In the first case, money entering the fund after an investor’s subscription is used to buy a selection of shares, representing a basket of collateral. The return on this basket is then exchanged (via an “unfunded” swap) with a counterparty for the return on the index.
In the second case, the money entering the fund is paid directly across to the swap counterparty (in a so-called “prepaid” or “funded” swap). The counterparty contracts to pay the fund the index return, as well as pledging collateral to the ETF’s account at the fund custodian.
Lyxor, Amundi, EasyETF, Credit Suisse and around half of db x-trackers’ funds (all the firm’s fixed income ETFs, plus its Euro Stoxx 50, DAX, CAC 40 long and short, and shari’ah-compliant ETFs) follow the first model.
The remainder of db x-trackers’ ETFs, as well as iShares’ latest swap-based funds, follow the second, funded swap model.
According to Ted Hood, CEO of Source, it’s definitely preferable to be the owner of the collateral basket than to have it pledged to you.
“Where there’s a pledge of collateral, in the case of the insolvency of the swap counterparty there’s a risk that a liquidator or administrator could step in and freeze all assets and liabilities of the bank concerned, even those that are clearly held in client accounts. This has happened with the Lehman failure, for example, and some investors are still waiting for their cash,” said Hood.
Dan Draper, Global Head of ETFs at Credit Suisse, concurs. “A swap-based ETF structure where the fund owns the assets is definitely more transparent and easier to understand than a structure involving a funded swap and a pledge of collateral. In the case of a credit event affecting the swap counterparty, the fund doesn’t need to prove to anybody that it is entitled to the collateral, as it already owns the assets directly.”
Not so, counters Manooj Mistry, head of db x-trackers in the UK. “We moved to the pledge structure early last year for a number of funds to make things more efficient operationally when moving collateral around. The law in Luxembourg governing collateral pledges is very robust and we believe that in some ways this is a safer arrangement from an investor’s point of view than owning stocks directly.”
“There are a number of trade-offs when comparing these two structures,” said Matthew Tagliani, executive director at Morgan Stanley. “Funds which own a basket of securities and which then swap the return on those securities for the return on the index are often more popular than those funds using the pre-paid swap model. This is because the absolute notional size of derivative exposure in the first type of fund is lower than in a fund that purchases a pre-paid swap. On the other hand, a fund with a pre-paid swap may have a higher level of notional backing through its collateral schedule, which can lead to overcollateralisation of up to 120%."
“In the case of the bankruptcy of a swap counterparty, it’s the job of the administrator to extract maximum value for the insolvent bank’s creditors. The administrator may therefore try to freeze the banks’ accounts until a full summary of assets and liabilities is compiled. So some delay might occur before the person to whom collateral has been pledged by the bank gets access to it and can liquidate it. Having said that, in the case of Lehman, while some investors have had to wait, we’re aware of others who were able to obtain their collateral and sell it on the day of the bankruptcy,” said Tagliani.
4. How Much Are The Swap Fees?
For those swap-based ETF providers that have to negotiate their swap contracts at arm’s length with third parties (notably Source, ETF Exchange and iShares’ new funds), it’s more likely that swap costs will be payable. These costs, in turn, will have an impact on the ETFs’ tracking difference from their benchmark.
For iShares’ new swap-based funds, launched two months ago, there’s a 0.3% trading cost on the creation or redemption of a swap, plus a variable annual swap fee that reflects the spread over Libor charged to the fund by its swap counterparties for replicating the index. In the case of the MSCI Russia fund, that’s an additional 0.77% per annum, while for the S&P CNX Nifty India fund it’s an extra 0.13%.
ETF Exchange also has to pay a fee (in the form of a spread over LIBOR) to its swap counterparties, according to its chief executive, Mark Weeks, in an interview earlier this year. The swap fees vary and reflect the market being tracked, he explained. The average ETF Exchange fund trailed its benchmark by 1.32% in 2009, well in excess of the ETFs’ total expense ratios, which range from 0.3% to 0.65% per annum, with the bulk of this additional underperformance apparently attributable to such swap fees.
Those ETF issuers using a single swap provider, typically their parent bank, to write their funds’ swaps claim that this allows them to avoid levying any additional spreads and to achieve better tracking. But since the cost of the swap also reflects the quality of collateral being provided in return, it’s important to look at these two parts of the equation together.
5. What Is The Dividend Tax Policy?
What proportion of the income deriving from an ETF’s underlying holdings is actually received by the fund? The benchmark the fund uses may imply one thing, while the fund actually receives a different percentage of dividend income.
For example, all the new European ETFs launched this summer to track the S&P 500 use the net total return index as their benchmark. This net return index is calculated by assuming that dividends are received after a 30% deduction for US withholding tax. At the S&P 500 index’s current gross dividend yield of around 2%, that tax deduction represents around 60 basis points per annum in income forgone.
However, all Irish-domiciled ETFs investing in US shares are eligible to use the Irish-US double tax treaty to reclaim some of the withholding tax, resulting in a deduction of only 15%. That’s an automatic 30 basis points “outperformance” of the benchmark.
Apart from raising questions about whether issuers are using the most appropriate benchmark, this example also serves to highlight the existence of such anomalies. As you might expect with tax, it’s a complicated subject to survey.
Furthermore, ETF issuers are often able to “enhance” dividend income by receiving dividends in a more favourable location (from a withholding tax perspective) than the fund’s domicile implies.
All these tax-related questions should be posed to providers, since they act as an important additional point of comparison between funds.
