Investing Basics: ETFs and Tracker Funds

The two most popular vehicles used to invest passively are index funds and ETFs (Exchange Traded Funds). The key difference between the two is that index funds, like traditional mutual funds, price once per day, whereas ETFs trade on an exchange and are priced throughout the day.

In their most vanilla forms, both of these vehicles provide low-cost and transparent beta exposure to a chosen market.

The majority of index funds and ETFs bought in the UK are physically replicated. In the case of full replication, the funds hold all the constituents of the underlying index in the exact weights stipulated. This straightforward approach makes most sense in the case of highly liquid indices, for example the FTSE 100, and we can expect tight tracking.

When indices are more difficult or costly to replicate, for example illiquid fixed-income indices or broad equity indices like the MSCI World, a fund may choose to buy a representative sample of the underlying holdings rather than to hold all index constituents. In this case, there is a trade-off between cost of replication and tracking accuracy.

Synthetic replication is another approach, although it is more commonly used by ETFs than index funds. Synthetic replication, due to the added complexity of using derivatives, represents the primary source of misunderstanding and misconception in the ETF space. Synthetic funds enter into a swap agreement with one or more counterparties (usually an investment bank) in order to receive the index return. This approach allows funds to accurately and consistently track their benchmark index, especially when underlying constituents are illiquid or not readily accessible.

While this approach introduces counterparty risk, it is always mitigated one way or another. For a start, the vast majority of ETFs and index funds are UCITS compliant (a number of ETFs listed in Hong Kong and Singapore are cross-listed from Europe and are UCITS compliant) and therefore subject to strict rules governing the collateral posted to mitigate this risk.

Under UCITS, a fund must be backed by collateral equal to at least 90% of the fund’s value. In practice, most synthetic ETFs are over-collateralised, which means that, in the event of counterparty default, the fund can theoretically liquidate the collateral and reclaim more than 100% of the fund’s value.

Of course when we analyse collateral we have to consider the quality, not just the quantity. What was considered to be robust collateral before the Lehman debacle and the European sovereign debt crisis is not necessarily seen as equally robust now.

These days, the major ETF providers generally seek a high degree of quality and consistency between the securities accepted as collateral and those included in the fund’s underlying index. So the collateral for equity funds is typically made up of highly liquid stocks, while that of fixed income funds would consist of investment grade bonds and cash. Beyond that, however, correlation is not always taken into consideration. But it’s not necessarily a bad thing. Having uncorrelated collateral could serve to ensure maximum liquidation value for fund holders in a default scenario.

Another misconception about synthetic products is their opacity, because, again, they use derivatives. As far as synthetic ETFs are concerned, this could not be further from the truth. Their level of transparency has dramatically improved in recent years, with detailed daily collateral holdings now available from most providers on their website, allowing investors to pass their own judgement on the suitability of the holdings. That much cannot be said about active funds using derivatives.

A last common misconception is that only synthetically-replicated funds have ‘things going on in the background’. In fact, physical passive funds, just like active funds, can engage in activities that introduce risks investors may not be aware of. We can estimate that 20-30% of physical passive funds in Europe (and some in Hong Kong and Singapore) engage in securities lending, which sees managers lend out a percentage of stocks in their portfolio to earn additional returns. This practice can be used to offset the costs of replicating the index, but does introduce an element of counterparty risk, which is also mitigated through collateral posted by the counterparties.

In sum, passive funds in their simplest form offer highly efficient and transparent vehicles through which investors can access a market. But when attempting to improve tracking performance through the use of enhancement techniques, fund providers can introduce an element of counterparty risk. It is therefore important that an investor feels comfortable with any additional risks borne when considering these funds.

Kenneth Lamont is a passive funds research analyst for Morningstar Europe.