tof apr morigstarco ews! 18970 PexAricleaspe ‘Understanding the Risks of Different ETF Structures {Investing always means taking risk in the expectation of @ reward; we take a took at the counterparty risks specific to synthetic and physical exchange-traded funds “Te strong growth ofthe Exchenge-Traéed Fune (ETF) market in Europe over the past years has rested in an increasing level of scrutiny by regulators, research bodies and med commentators. This growing level a crtny has proved someting ofa cowle-esges Ward. Oa the plus side, iS an expt acknowledgment tat the notion oF "pareve Investig” i sing groune amongst Investors. However, in many Instances the ETF Industry hasbeen unary singled out for issues - mally pertaining to sk = that do really affect he Investment fund industry asa whol. ‘Whether active or passive, investing always means taking sts Inthe expectation of ‘reward. Reduced to thal simatet expression we can eri to broed estepores of rs, ‘namely investment and structural, Investment ak relates to the merkot performance of tie ssc, while srucurl rik relates to the product used to ives inthe asset. Investment se 'Suravoidabie, bu oking on structural risk shouldbe 2 mater of personal coie In Europe, the debate abou structural rk in ETFs hes ava’ been entwined with that about replcaton methodology. There are two strands of ETs in the European marcetpace physical ETFs, which replicate the index thay track by physiealyboldng al, or 8 representative sample, offend constituents; ana the so-called synthe” ETFs, which ever the index perormance Via @ snap antec. ‘Conceptualy ts much easier to explain wratprysicalrepaton i. However, would be & stake to equate "easy to understand” with posing las Structural rik", And et, this precisely what some do, cting the existence of snap counterparty ris synthetic ETFe at ‘wnequvocl proof Homever, counterparty risk can also exe in physical ETFs, provided they lena out te tna’ constituents. And the main provisers of physical ETFs in Europe acaly ©. "ion, fis important to stress that counterparty risk (Le. thers thatthe other party in 8 financial contract fal tou ts ebigatons) isnot prvy to ETFs It cn ago affect 2 ‘ulttce of er Investment vehices, including Wratonal mieva finds, which also engage In secures lending ectvtes andor use derivatives, Nevertheless, when comes to ETFS, Investors and their advisers must make sure to understand the nature of tis structural is qual, they must aso be abe to judge whether the peotecve measures in place agent as well as the compensation for aking are acequate ‘The Use of Swaps in Synthetic ETFs ‘Synthetic Ee deliver the performance ofthe index they track via @ sap contract, The ETF ‘manager bulls a so-called “suostute basket” ~ sometimes ela calle “aiateral basket” with a mic af assets that may or may not beer any reletion tothe index he TF tracks, and ten enters into asap contract wits a counterparty ~ normally n investment ban = whereby Ieexchanges the performance of such a basket fr that ofthe index. For this reason, ‘counterparty ris Intrinsic to thelr structure. Tis means that investors are iremediobly exposed ~ a east theoretaly~ tothe risk thatthe swap counterparty fl to deliver the performance ef te index. While there may be mutipe reasons why the may happen, the ‘erst cas seanario would be where the ssp counterparty simply goes bur Irerpecive of the couse, the ETF investor would be oR withthe contents of the “abet basket” as inno 1206,rw nnangst co Wns! OSSTPATCeaspe colateral Tels generally accopced that investors in synthetic Es are compensated for taking on 9p ‘counterparty sk wit the reward f comparatively lower management fees and more scavate tracking viei-vis ETFs employing psa epleaton techniques. But tere Is ao 2 sis of regulatory messures tat providers of eynhetc ETFs must comply Wi as a means of protecting Investors against tis counterparty sk. Under UCTS rules, for example, the net counterparty risk exposure ofan investment fad (Le. not jst ETF) to any single asuer ‘ia a derivative (e.. swap) cannot exceed 10% of NAV. In elec hs ment that 9% of ‘he ETF must be colatralises Jn reeity though, the major of synthetic ETE providers ether fly oF over coatraise thelsmap exposure ona voluntary basi, thereby increasing te eve of protection aforded to vestor, Furthermore, parla! to the voluntary enhancement af ealtrel requirements, provicer fsynetc ET have ales made mejor Improververts nthe area of tanapareny. For example, online disclosure ~ mostiy ona daly bess ~ ofthe composition ofthe *eobstute basket has become the norm, This vel of transparency Delp investor synthetic ETS to properly assess risk Securities Lending in Physical ETFs ‘Securities lending ste process of leaning ase toa third party in exchange ror a ee. Some, though not al providers of physical replated ETFs have secries lending ‘roprammes in pace witn the objective of generating revenues thet might partly, ori Some cases completely, oft management ear srl ther sources of index tracklng Aiterence, Counterpart risk inthis context arses from te fat thatthe borrowers ofthese assets might not return tham to the ETF manager Itlsimporantto underine that, unt the use of aps for synthetic ETFs, secures lending 'Sot a necessary practice for physical ETPs to deliver the performance ofthe Index they lrock Rater, the aim of «secures lending programme Isto improve the ETFs tacking perormance. AS sich, exposing Investors tote counterparty es aising from secures Tending becomes a mater of choice by ETF providers. However, the choice of seroming sich sk should ultimately he with the investor. Hence the read forthe umos degree of transpareney onthe ETF provisers’ sie a o whether tay engege In these practic, wht protective measure ae in place, and what benef iwestors may draw The level of dstesure aroun secures lending practices by providers of physi ETFs hes Improved substaraty over the past couple of ers. Some my erqe tis 0 et optima. However, compared tothe secrecy surrounding these prectcasin the acvely-maraged ‘mutual find industry, ETF providers canbe fry cescribed as an "open book In terme of protative measures, Ithas become common practic or providers of physical ETF that engage in securites lending to ele uly x over ealatraise the loans. Ie 20 Important to nate tat wl tere fn reguletory init the amount 2 fund ca lend ou some ETF providers have voluntary adopted maximum aniean limi. Some alsa oer Indemnification (insurance) against potential lases ‘Meanwhile, onthe esue of bereits, the guidelines published in July 2012 by the European ‘Securities and Markets Authority (ESMA) estabssh total revenues arising from secures lending precties, net of crect and indirect operational costs that must be expcyalcesed ‘on he prospectus, shouldbe returned to the EF. Quality of Collateral is Key Ircespective of whether one opt oinvestin a syrthetic ET or in a physical ETF whieh engages insecurities lerdng, te degree of protection against counterparty rik wil dos ar22013 06 PMnse ines TOSSTOPHWARicle SPE itimataly be a measure ofthe avallable colateral The quantitative aspect of the collaterals Important and one wherethe more the beter isthe averiing rule. However, inthe event of eaueerparty default, the evel of compensation wort be sae determined By quetty, butby whether the collateral sof good enough quai to be quate fst and ata flr price, And yet, evaluating quality isnt a straightorward task If pushed, we woulda be be to come up witha rough casefcaton of aseete on the basso persives theoretical Securty. Nonetheless, the aby ose any asst, andthe pic at whch can De so, wil Utmataly be daterminad bythe markatervironment atthe tine of the transaction, Some ofthe guidlines published by ESMA ast year touched on te leue of collateral quality ‘Amongst others, factors such as high uit, high edi rating, transparent pring, and ‘suffcenteversfeation of collateral assats are ke towards minimising the chances cf 2 shortfall when udating collateral, many ase, th complete elimination ork doesnot seam posible. But then agen, tis fpreisty the assumption of sk tet tingle inuettors rom savers. What should matter for investors assuming rik of any kind iste do so fly aware. Arn that respec, ETFS have set high standards of transparency ~ certainly much higher than these apaied by the actvely-managed muti fund industry ~ Wat allow investors to do just that ‘Scone 2012 Marina Aes eee ricinus oh ares preg tout ten cosa frm Momma af i201 06M