To explain it simply, the objective of these swap-based ETFs, as with all other ETFs, is to track the performance of a chosen index. These swap-based ETFs will hold a basket of stocks. If these basket of stocks underperforms the chosen index, another party will have to make up the difference in this underperformance to the ETF so as to allow the ETF to fulfil its objective of tracking the index. On the other hand, if this basket of stocks outperforms the chosen index, this difference will be paid to the other party since the ETF is only required to track the index. Nothing more or less.
On the other hand, cash-based ETFs are the traditional type of ETFs. Their model is simpler as compared to swap-based ETFs. Basically, they hold a basket of stocks that replicates a chosen index as closely as possible and this basket of stocks is divided into units where it is traded on the stock exchange.
Why is there a need to understand these two types of ETFs ? This is because there is an additional risk between these two types of ETFs which investors will need to know.
For swap-based ETFs, there is an additional risk which cash-based ETFs does not face and that is counterparty risk. For example, one particular swap-based ETF is tracking an index and for this specified time period, the basket of stocks which this ETF is holding on to, underperforms the index by a significant percentage. As such, the counterparty is required to pay this difference. Now what happens if this counterparty is not able to pay up ? This is one issue which investors of swap-based ETFs may have to consider. However, this counterparty risk is limited to a certain percentage of the value of the fund under regulations so the risk is not that high though it will still be there.
Furtheremore, swap-based ETFs tend to have less transparency. Investors may not know the details behind the swaps such as the value of the swaps and the collateral that are being used for the swaps.
(Taken from Barclays Global Investors)
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Great post about ETFs, it will surely help many people who want such good information on this.
ReplyDeleteKay,
ReplyDeleteAs usual, one can expect interesting articles from you.
While I see a disadvantage in Swap-based ETFs, where is the advantage in investing in such products? Tks.
Hi Alex and VS Lingam,
ReplyDeleteI hope that this post is useful indeed. Swap-based ETFs are useful in creating ETFs when access to the stocks of a particular index is limited. This explains why there are so many ETFs available in the market these tracks various countries and sectors these days. So there is a greater variety of ETFs for investors to choose from.
However, do take note that just because there is a greater variety of ETFs does not mean that investors will be able to use them to achieve a better performances. Personally, I'm not too impressed by some of these ETFs such as short ETFs and ETFs that focus narrowly in a particular area. In facts, ETFs is a misleading term for such instruments and it will be better to term them as exchange traded structured instruments.
My advice is that one go with ETFs that tracks the index which would represent the economy of a country as a whole. These includes the Dow Jones Industrial Average, S&P 500, Hang Seng Index, Straits Times Index etc.
Kay
Hi, Kay,
ReplyDeletewondering whether you have used credit card to purchase share b4, thanx :)
Hi Zzz,
ReplyDeleteI have not done that before. In general, I don't advise you to buy anything on credit unless you are very sure that you can pay it off before the interest rate kicks in. It is better to save a sum of money after meeting your needs before you start to invest.
Kay
Hi Kay,
ReplyDeleteIs the Lyxor China ETF and the Lyxor Russia ETF that is traded on SGX both swap based ETF ? Pls advise.
Thank you
Phyllis
Hi Kay,
ReplyDeleteI am interested to buy ETFs that accesses the emerging markets ? Any such cash-based ETFs available in SGX?
Hi Phyllis,
ReplyDeleteI have not read the prospectus of the both ETFs that you have mentioned so I can't confirm whether they are swap-based ETFs. Probably I will glance through the prospectus over the weekend and post another comment here but the impression I am getting is that both ETFs are not cash-based.
Kay
Hi,
ReplyDeleteCan you list out some ETFs that tracks the emerging markets which you will be interested in it ? Perhaps, I can go through the prospectus and let you know again. Thanks.
Kay
Hi Phyllis,
ReplyDeleteBoth of the Lyxor ETFs that you have mentioned are swap-based. You can download the financial report of the Lyxor China ETF and look at the assets held by the fund. It seems to me that most of the securities held by the fund are not the constituent stocks that are in the index that it is supposed to track. However, the swaps are only limited to 10% of the fund.
Kay
Hi Kay,
ReplyDeleteLooking at the annual report as at 30 Apr 09, of Lyxor China ETC, it seems that almost all of their holdings are European stocks (and very little Chinese stocks, if any). Are they still adhering to the 10% swap policy?
Not sure if I'm reading the annual report properly, or if I understand the swap policy correctly.
Thanks.
Josh
Hi Josh,
ReplyDeleteThe 10% swap policy does not means that 10% of their net assets can consist on stocks that are not from the China stock market.
This 10% policy is only applicable for European-based ETFs under the UCITS rules. It means that value of the counterparty exposure to the swap provider is capped at 10% of the net asset value of the ETF. So this Lyxor China ETF can still be holding European stocks and adhere to the 10% swap policy.
Kay
Hi Kay,
ReplyDeleteGiven the fact that they hold mostly non-Chinese shares and the swap is limited to 10%, how can they track the index accurately?
Hi,
ReplyDeleteI'm not that sure but from what it seems, the swaps are limited to 10% per counterparty. So they can have more than one counterparty. Besides, they can select a basket of stocks which is highly correlated to the China stock indices. In fact, swap-based ETFs track the index more accurately than traditional cash-based ETFs.
Kay