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Forward Thinking Magazine : August 2011
53 Are all ETFs the same? Surprisingly enough, this was a controversial question a decade ago. However, at that time, the controversy was limited to the Australian market only -- ETFs listed in other markets at the time generally conformed to a consistent set of design principles: 1. Open-ended investment vehicles, designed to replicate index returns. Index returns are achieved by using a physical replication approach, whereby the vehicle in the securities included in the index, in their respective proportions as specified by the index provider. 2. The vehicle is listed on a securities exchange, enabling units to trade intra-day and settle T+3, similar to an ordinary share. 3. Comparatively low ongoing management fees, attributed to a relatively stable portfolio of underlying investments and the operation of a primary market for the creation and redemption of units concurrent with the secondary exchange traded market. The primary market operates through exchanging a physical basket of securities in specie for units in the ETF. 4. Transparency in terms of the underlying investment portfolio. To facilitate the operation of the primary market, the ETF issuer publishes a daily list of the basket of securities that comprise a 'creation unit'. This details the physical portfolio of securities that the issuer will accept (return) to the applicant if an order to create (redeem) units in the ETF is lodged that day. 5. Reliance on arbitrage between the primary market and the secondary market as the primary mechanism to ensure that units are traded on the secondary market close to their net asset value. Briefly, if the units are trading at a significant discount to net asset value (NAV), an arbitrageur can capture the benefits of that discount by acquiring the units on-market at the discount and placing a redemption order to swap the units for the underlying basket of shares. In the process, the quantity of units available to be traded on-market is reduced and the imbalance between supply of, and demand for, units that generated the discount in the first place is addressed. The reverse applies should the units be trading at a premium, which can be captured by swapping a basket of the underlying securities for additional units in the ETF and on-selling these in the secondary market. In 2001, the term 'classical ETF' was adopted by the ASX to describe ETFs that conformed to these norms; 'hybrid ETF' was used to describe listed managed funds that exhibited some, but not all, of the characteristics outlined above. Classical ETFs have endured, with the majority of the ETFs now listed and/or traded on the ASX conforming to this structure. Hybrid ETFs appear to have progressively morphed into another discrete category -- Listed Managed Funds -- insofar as the ASX is concerned. In more recent times, another point of distinction between different types of ETFs has emerged. ETFs are increasingly classified not only around the nature of the benchmark being tracked (market, sector, style), but also in terms of the underlying investment management strategy used to replicate returns on the index being tracked. Taking this latter approach, ETFs can be classified as either: 1. Physical ETFs, where the investment manager holds the actual basket of underlying securities or assets that comprise the benchmark being tracked (i.e. physical replication is relied upon to achieve the target returns, consistent with the design principles that were adopted for the original ETF listed in Canada in 1990). 2. Synthetic ETFs, which rely on the use of derivatives to achieve returns consistent with the benchmark being tracked. While synthetic ETFs generally enable much more precise tracking to the underlying benchmark, full transparency over the portfolio of underlying holdings is generally not available. Depending on the specific nature of the arrangements adopted, synthetic ETFs also might expose the investor to additional counterparty risk associated with the derivatives provider(s). It is the increased complexity, lack of transparency and potential for increased counterparty risk associated with synthetic ETFs that has generated the heightened regulatory scrutiny of late. For ETFs listed on the ASX, this risk is mitigated somewhat as the ASX has effectively capped the counterparty exposure for synthetic ETFs by requiring that no more than 10 per cent of the ETF's NAV can be subject to money owing under derivatives. So, what does this mean for advisers looking to include ETFs in their advice model? As with any other managed investment, it helps to understand not only the objectives of the fund, but the mechanics through which the fund seeks to achieve its objectives and the various counterparties that are involved. The author was the ASX's project owner for the launch of the ETF market in 2001. The views expressed here are the author's own.