Exchange-traded funds

Exchange-traded Funds are synonymous with index trader. They are passive investment funds traded on the stock exchange with the aim of tracking the underlying stock market index or benchmark as closely as possible.

Tracking the stock market index by replication

The stock market index is tracked using two methods:

Physical replication

An ETF that uses physical replication buys virtually all of the stocks, or bonds, that make up the benchmark index to replicate the index’s performance.

Advantages:

Transparency and simplicity

Disadvantage:

Fees and tracking error are higher compared to synthetic replication funds.

A physical replication of the AEX index (1) with 25 liquid shares is easier to realize than the MSCI World index (2) with 1600 companies. In (2), the ETF manager may choose not to include small, less liquid companies in the ETF. The deviating portfolio vs. the index is one of the causes of the tracking error.

Synthetic replication

A synthetic replication ETF enters into swap agreements with one or more counterparties to provide the return of the index. In the swap, the swap counterparty insures the index return in exchange for the return of the collateral or the money of the investors in the ETF. Because the swap provider is responsible for delivering the index return, the ETF provider has no or minimal tracking error relative to the benchmark index. However, a counterparty risk clearly arises for the investor, because the swap supplier may not be able to meet its obligations. The use of multiple counterparties can mitigate these risks, but not completely eliminate them.

Swap risks

Risks with swap-based structures

– Counterparty risk
– Concentration risk
– Interest conflict
– Collateral risk

Benefits

– Lower management costs
– The Total Expense Ratio (‘Total Expense Ratio’ or TER) = 0.5% / compare with + 2% costs of traditional investment funds.
– They don’t try to be smarter than the market, so they don’t have to hire expensive analysts. A computer program does most of the work.
– In addition, ETFs are generally fully invested, so there is no low-performing cash in the fund.
– The investor is sure that the return of his investment will not be worse than that of the index. He does not run the risk of becoming a victim of a fund manager with an incorrect investment view.

Options

The ETF is based on an index. Usually, the ETFs are traded by professional parties with a future on this index as cover. However, other financial products can be launched on the ETFs. For example, Euronext started trading options on the iShares DJ EuroStoxx 50 tracker on February 18, 2008. In the United States, options on trackers are very popular and liquid.

Difference with index fund

The difference between an index fund and an ETF is that the latter is continuously traded on the stock exchange. Index funds are typically traded once a day. In addition, an ETF offers tax benefits due to the difference in structure compared to traditional index funds. The main difference between an ETF and an index fund is that an ETF is often not limited to one index, but contains stocks from many indexes.

Regulation

The international association of securities regulators IOSCO has established principles for regulating exchange-traded funds. The principles provide more clarity about the provision of information such as cost transparency, distinguishing between ETFs and other investment institutions and transparency about the index that is being tracked.

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