By Genevieve Cua

MENTION exchange traded funds (ETFs) and most investors are likely to think of listed funds that physically hold an index's underlying shares. But an increasing number of ETFs are actually synthetically structured - that is, the ETF itself does not physically hold an index's component shares, but it tracks an index through derivatives. In Singapore, of more than 30 listed ETFs, more than half are swap-based.

This raises an interesting question: Are swap-based ETFs a form of structured product? How suitable are they for retail investors who may not fully understand the structure itself and the risks?

To throw light on these questions and better highlight the risks, we sent some questions to three major ETF providers - Deutsche Bank (DB), iShares and Lyxor. DB offers ETFs under its db x-trackers series. DB and Lyxor's ETFs are swap based. iShares, a giant in the ETF arena, offers both cash-based and swap-based ETFs.

In a recent BT Weekend edition (Aug 1), we looked into the distinctions between cash-based and swap-based ETFs. To recap, ETFs broadly seek to replicate a market index.

Cash-based ETFs hold all or a representative sample of an index's constituents. This makes them transparent and fairly easy to understand.

Swap-based ETFs, on the other hand, use swap arrangements to replicate markets where access may be difficult and liquidity poor. In these ETFs, the fund holds a basket of securities which may be completely unrelated to the index it is tracking. It enters into a swap arrangement with a counterparty where the latter undertakes to deliver the performance of the index to the fund. The fund will deliver the returns on its basket of securities.

At least one advantage of swap-based ETFs is that it results in a closer replication of the index, thanks to the undertaking by the swap counterparty. Here is a bird's-eye view of some issues that may be of concern, given the use of derivatives.

Q: What happens if an ETF manager fails?

Joseph Ho, managing director and head of ETF sales and marketing (Asia-Pacific) for Societe Generale (SG), says that ETFs are mutual funds so their assets are segregated and held by a trustee or custodian. 'As such, the failure of the manager will not result in direct loss of assets.' Mr Ho markets Lyxor funds under the SG group.

Should an offeror go bankrupt, the depository or custodian with the regulator could try to find a replacement manager.

'Failing that, the fund could be liquidated and the proceeds from the sale of assets be distributed back to unitholders according to their respective ownership,' he says.

Q: What about the failure of a swap counterparty? Under UCITS III, losses arising from a single counterparty are limited to 10 per cent, but is this a guarantee? (UCITS III is the funds registration regime in Europe that serves as a funds marketing passport. Many unit trusts and ETFs here are UCITS III funds.)

Jane Leung, iShares Asia-Pacific senior director of product, says that, theoretically, the value of the fund will be reduced by the value of the swap issued by a counterparty that has defaulted, less any collateral value.

'It is important to choose an ETF manager who has a strong heritage of performing fiduciary duties and actively monitors counterparty exposure. Investors should also take note of the quality of collateral used to back the ETF.'

SG's Mr Ho says that a counterparty that defaults or goes bankrupt could wipe out the value of the swap. 'So the actual loss to the fund will depend on the weight of the swap at the time of the failure.'

UCITS III limits the exposure to a swap provider by up to 10 per cent, which is a plus for investors. But there are other factors that come into play in terms of the actual value investors can realise.

DB xtrackers director Marco Montanari says that the limit of 10 per cent is applied on a 'continuous' basis and means that the net asset value can drop by up to 10 per cent due to a counterparty default.

'However, it should be noted that the fund value will then depend as well on the value of the assets and collateral held by the fund upon liquidation.'

The board of directors of the fund company could step in to try to find a replacement swap counterparty, although there is no obligation to do so, he says. In the absence of a replacement, the fund could be liquidated.

Q: What sorts of securities do your ETFs hold? Are these disclosed to investors and are they related to the index the ETF tracks?

Mr Ho says that as the ETF receives the benchmark performance through the swap, and the stock basket's performance is given away, no performance issue arises from the stock basket.

'The only time the stock basket plays a role is if the swap issuer fails and the fund needs to liquidate the basket. For this reason, it is always made up of bluechip stocks that are liquid and cost the least to trade.'

He adds that the stocks are chosen to optimise costs. Holdings of Lyxor ETFs are available in their annual reports.

DB's Mr Montanari says that the swap counterparty can only post cash or liquid securities according to UCITS III regulations. The actual securities may change from time to time and are not set out in the prospectus.

'DB is able to disclose this information to investors on request and we are currently working to make this information available on our website,' he adds.

iShares' Ms Leung says that the firm discloses its ETF holdings daily on its website. For swap-based ETFs, the type of derivative used and counterparty exposure are also disclosed daily.

Q: Swap-based ETFs may be seen by some as structured products. Is it a misnomer to call them ETFs given their complex structure?

The offerors emphasise that swap-based ETFs are structured as mutual funds or collective investment schemes. This is distinct from structured products which are bespoke arrangements, where counterparty exposures are mostly 100 per cent. As they are not listed on exchanges, liquidity is also an issue and valuation isn't transparent.

UCITS III funds allow the use of derivatives subject to limits. Mr Ho says: 'The key is the limit on derivative exposure.'

Mr Montanari says that swap-based ETFs are common. In Europe, assets in swap-based ETFs at US$50 billion account for over half of the total assets under management in the European ETF market.

Barclays Global Investors estimates the global ETF market to be worth US$862 billion as at end-July.

Q: How appropriate are swap-based or synthetic ETFs for retail investors who may not understand how swaps work?

Investors, says Mr Montanari, should read prospectuses carefully and make sure they understand the risks of any type of ETF. 'All direct and synthetic replication techniques involve risks that are detailed in prospectuses.'

Ms Leung says: 'We face a diverse group of investors - some more sophisticated than others. Our view is investor education is key. (People) should only invest in products they understand.'

This article was first published in The Business Times.