Swap-based ETFs do not solely rely on the credit quality of their bank counterparties to back the assets of their funds. In fact, such a structure is not allowed in Europe’s UCITS regulations for traditional funds. Instead, these ETFs hold a basket of stocks and bonds (typically chosen by the counterparty bank) in the fund, which serves as a safety net for investors in case the investment banks collapse. So far, so good. However, it used to be quite difficult to find information about this basket of collateral securities outside of the snapshot in these funds’ annual reports.
Many investors and followers of the ETF industry (including ourselves) have been calling for more regular disclosure of the composition of swap-based ETFs’ substitute/collateral baskets for some time now. Since these securities are what investors actually own in the case of a default, this was one of the critical pieces of hard-to-find information. Luckily, these calls haven’t fallen on deaf ears. In the coming weeks and months, some of Europe’s largest providers of swap-based ETFs--including Lyxor, db x-trackers, and Credit Suisse--will be disclosing the composition of their substitute/collateral baskets on a daily basis on their Web sites.
We view this initiative as a sign of goodwill on the part of ETF providers. While investors will in many cases not be able to make sense of the composition of these baskets--as they often bear little resemblance to the funds’ reference indices--regular disclosure will allow for greater scrutiny of the assets backing these funds. This in turn will ensure that these baskets are consistently comprised of high-quality, liquid securities. Independent research groups such as Morningstar will no doubt scour these new disclosures and try to provide a better sense of the collateral portfolios’ safety.
In most cases, many of these providers have already been following suitable policies with regards to the composition of these baskets, so daily disclosure is merely a matter of drawing back the curtains to allow investors to peek in on what are already sound practices. However, other providers--most notably ETF Securities--continue to shroud their practices. This latest move towards fuller transparency will ultimately either widen the gap between the ETF vanguard and those less committed to full transparency, or it will force all providers to adhere to what we believe should be standard practice--constructing substitute/collateral baskets comprised of high quality liquid securities and providing daily disclosure of their composition. We view this as a win-win proposition for investors and ETF providers.
For more on this subject, please see our recent article Synthetic ETFs: How Protected are You? or the archive of our July webinar Identifying ETFs’ Hidden Risks.
