Unwrapping a complex fund: the need for transparency

TRANSPARENCY has been one of the buzzwords of exchange-traded funds (ETF) since they arrived here in Europe just over a decade ago. Providers have been keen to push just how transparent their products are.

But the way that synthetic ETFs are created has clouded the issue somewhat, especially in the wake of the financial crisis. Synthetic ETFs have come under fire in the last 12-18 months for not disclosing in sufficient detail which securities they actually hold and consequently, what investors are exposed to.

Therefore, providers have been on something of a transparency drive with Deutsche Bank’s ETF division db x-trackers the latest to join the party. Investors using db x-trackers will be able to see an ETF’s composition in terms of security type, sector, country and currency, which will be updated daily.

Credit Suisse was the first European ETF provider to publish daily collateral holdings while BlackRock’s iShares has a similar promise on its recently launched swap-based platform. Source ETF publishes benchmark constituents and weightings on a daily basis.

Unlike traditional ETFs, synthetic ETFs hold a basket of securities that may be completely unrelated to the index they are tracking. The ETF provider will then typically enter into a swap arrangement with a counterparty – usually an investment bank – where the performance of the basket is exchanged for the performance of the reference index.

Indeed, occasionally the swap performance has been so good that the ETF has actually been outperforming the underlying index, points out John Davey, senior analyst at BestInvest.

Under Ucits 3 regulations, counterparty risk is limited to 10 per cent, which means that the ETF issuer or the swap counterparty must provide collateral worth at least 90 per cent of the ETF’s net asset value. Many providers now also choose to “overcollateralise” – that is, hold more than 100 per cent of the ETF’s net asset value (NAV).

Although Lyxor ETF has decided not to do this, it is still keen to ensure that it remains transparent and will provide information about the composition of the swap basket to clients on request. It also does not lend out assets held in the basket to minimise counterparty risk.

Lionel Phillips-Franjou, head of product development for Lyxor ETF, adds: “We make sure that the ETF is sufficiently liquid and that it is managed in the proper way, which includes strict risk monitoring both at the level of counterparty risk and in terms of diversification issues.”

Source also takes a different approach and holds 99.8 per cent of its synthetic ETF assets in listed equities and only uses a small amount of derivatives in return for significantly improved performance, says Source’s Michael John Lytle.

While BestInvest’s John Davey says that any improvements to transparency must be welcomed, he does say that daily disclosures of collateral could be seen as information overload for the retail trader. But if you’re holding ETFs in size, or simply interested in what you are trading, then it’s worth checking what your ETF is holding.