2nd Part of Passives

Continuing on from our last Thought about index trackers and their complexities, this week we focus on the more complex vehicles available to UK investors.

Synthetic ETFs

Synthetic  ETFs are more complicated than physical ETFs. The recent press coverage of ETFs has focussed on this type of tracker. In reality, synthetic ETFs trade like physical ETFs, except:

• They don’t actually own the assets of the indices they track.
• Instead, they buy a total return swap. That’s an agreement with another financial entity to pay the ETF the return of the index.
• The ETF is exposed to counterparty risk the swap provider defaults.
• European regulations limit the counterparty risk exposure to 10% of the ETF’s net asset value but in reality this is close to zero for most.

Collateral is used to cushion the ETF from counterparty disaster.

ETCs – commodity or currency tracking

Exchange Traded Commodities (ETCs) can track everything from gold to leveraged soya beans but they’re not as straightforward as ETFs:

• Only a few precious/industrial metal ETCs can afford to physically hold commodities, which enables them to track the current (spot) price.
• Most ETCs track their commodity’s futures market. Returns on futures differ from returns on spot prices.
• Some ETCs track single commodities, others a broad basket.
• ETCs are structured as debt instruments to avoid regulated rules on diversification.
• Investors are exposed to counterparty risk (up to 100%).

ETNs and Certificates

Exchange Traded Notes (ETNs) and Certificates are cheap and potentially very risky. There are many variations on the theme, but basically they track an index, are tradeable on the Stock Exchange, and:

• They’re debt instruments issued by a single party (normally a bank).
• The bank agrees to pay the return of the index on the product’s maturity date.
• The underlying assets are not physically owned.
• If the bank goes kaput you’re in trouble.
• Counterparty risk exposure is up to 100%.
• They’re a low cost way to enter hard-to-access markets.
• Tracking error is low – it amounts to just the fees.

The active investment industry in the UK has found arguments for not using index trackers in client portfolios for many years. The increasingly complex nature of index tracking vehicles has provided many of our peers with another excuse for not using these cost effective instruments in client portfolios.

We hope that the overview of the types of funds available and their relative merits/drawbacks will  give comfort to readers that, at Tacit, we keep a truly open mind to portfolio management and continue to focus our attention on analysing the facts.

Opinions constitute our judgement as of this date and are subject to change without warning.