Non synthetic ETFs

Shaz

Registered User
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I am interested in purchasing ETFs.
How do I pick the ones that are basic, no frills and that just track a common index i.e FTSE 100, S&P 100 etc. I have read about “synthetic ETF” that are derivatives based and I want to avoid these!
I have read the threads on ETF but still do not know how to purchase an ETFs that track shares in the UK, Europe and the US. Please advise.
 
You can trawl the main ETF websites.

ishares
State Street global advisors
Lyxor
db x-trackers
PowerShares

and others

Rory Gillen
 
You need to do your research to avoid synthetic ETFs.

Lyxor ETFs, for example, are synthetic and as result you may be exposed to some pretty unattractive counter-party risk; in this case the counter-party is the struggling French bank, SocGen. As a result it seems investors have been withdrawing from holding these ETFs. Read this article for details.

Before the financial crisis, this sort of counter-party risk was viewed as insignificant. Now it should be considered a highly significant factor for ETF purchasers.

Perhaps this fact should be highlighted in one of the key posts here? I.e. there are extra risks associated with holding synthetic ETFs. And given there are often closely related alternatives, there is no good reason to expose yourself as an investor to these risks by buying synthetic ETFs that I can see.
 
Hi Darag or Rory

Would one of you like to do a summary post on the issue.

Explain what a synthetic ETF is and how you can check whether or not it is synthetic.

Brendan
 
Hi Darag or Rory

Would one of you like to do a summary post on the issue.

Explain what a synthetic ETF is and how you can check whether or not it is synthetic.

Brendan

Brendan,

I'm happy to post a PDF eBook that I have written on ETFs - any problem ?

Rory Gillen
 
Brendan,

I can't post a link as my website needs a password. I'll download relevant paragraphs from a note on ETFs and post that later.

Rory
 
At Brendan's request, the following is a short explanation of the different forms of ETFs & ETCs, relevant counterparty risk and related issues in Irish unit-linked funds.


ETFs & ETCs – Two Forms
The basic ETF comes in two forms. The first is a fund that uses its cash to buy the physical assets outright. The fund then has the flexibility to engage in stock lending to generate extra income, or to employ dividend enhancement activities, as most ETFs do. These activities, of course, expose the fund to modest counterparty risk.

The second form of ETF is one that does not buy the underlying assets of the index it is tracking but, instead, buys a swap-based product (or derivative contract) from a third party (counterparty), which is designed to replicate the index returns for the fund. Swap-based products or derivative contracts involve counterparty risk. Given the calamity in financial markets in 2007-2009, where the survival of many financial institutions was in doubt, this risk reared its head, where previously counterparty risk was not considered an issue when dealing with the major investment banks worldwide. In spite of that, I would not overplay the risks. Under European UCITS regulations, the exposure to any particular counterparty is limited to 10% of the fund value. Also, particular sponsors can offset counterparty risk in a variety of ways.


Exchange-Traded Commodities
Exchange-traded commodities (ETCs) are open-ended securities that trade on regulated exchanges. In technical terms, they are secured, undated, zero coupon guaranteed notes issued by special purpose vehicles with segregated liabilities, and are generally protected by trustee structure. They are designed to accurately track the underlying performance of the commodity index or individual commodity. In the case of physically-backed ETCs, the structure is probably even more robust than many ETFs, which often have counterparty risk through their stock lending activities or dividend enhancing strategies.

ETCs enable investors to gain exposure to commodities without trading futures or taking physical delivery. Similar to ETFs, there are two types of ETCs. The first is an asset-backed ETC that is fully backed by the relevant commodity. For example, several of the gold ETCs are securities backed by the equivalent amount of gold bullion, with the bullion being deposited and stored in a bank vault. The second, and more common type, is a swap-based ETC which is a security backed by a swap-based (or derivative) contract.

The most comprehensive site covering ETCs is the London-based ETF Securities ([broken link removed]). The majority of ETF Securities swap-based ETCs are backed by 100% collateral held by Bank of New York Mellon. This eliminates counterparty risk attached to any particular swap-based ETC sponsored by ETF Securities.



Counterparty Risks in Irish Unit-Linked Funds
Irish-based investors have always, perhaps unknowingly, had to accept counterparty risk when buying into unit-linked funds from the Irish providers. The safety of investments held in a unit-linked fund is dependent on the health of the insurance company backing it. Unit-linked funds are not separate entities from the insurance companies promoting them. In effect, the assets of the unit-linked fund remain the property of the insurance company, which in turns gives the investors the commitment that they get the returns that the underlying fund delivers.

Thus, key questions for the ETF/ETC investor include:

¨ What index or asset is the product tracking?
¨ How does the ETF replicate the performance of the asset/index?
à Does the ETF own the underlying assets?
à Does the ETF use derivative contracts?
¨ What is the counterparty risk?
¨ What is the annual total expense ratio (TER)?
¨ Is the dividend income paid out, how often?
¨ What are the taxation implications of selling a particular ETF?




Rory Gillen
 
To the above list I would add that you should also check the size of the ETF issue and the volumes traded to avoid liquidity risk. This would not have been a factor in the past but there are so many ETFs these days some of which are tiny/niche.

For example, on average over $400m a day worth of the popular iShares Standard and Poors 500 index (symbol IVV) is traded while I checked one of their small property based ETFs (symbol RTL) and less than $14,000 worth is typically traded per day. With such small volumes, the incentives for arbitrageurs will be much less; as a result the spreads will be wider making it more expensive to buy/sell the ETF.
 
Absolutely agree that there are significant issues around executing ETF trades.

However the disclosed volumes are not always a reliable guide as I understand that a significant proportion of trading volumes are not reflected in the turnover figures shown by the exchanges.Apparently a lot of the 'action' goes on with Authorised Participants who are effectively market makers.
 
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