Why structure matters when choosing your next ETF

If you’re among the millions worldwide considering diving into the world of exchange-traded funds (ETFs), here’s what you should know first.

What are ETFs and what do they do?

You can buy or sell an ETF just like shares in a company, meaning at any time during the day’s trading window. They’re incredibly popular for being low cost and offering diverse exposure to stocks, bonds, commodities, and more—sometimes all in one investment.

Rather than paying someone to try and outsmart the market, most ETFs follow a passive approach. They try to replicate the performance of a specific index, like the FTSE 100 Index in the UK or the S&P 500 Index in the US.

In theory, you could buy shares in each company in an index yourself. But that would be a tough and costly task. Opting for a purpose-built solution is much simpler and more budget-friendly. For instance, if you’re optimistic on the UK market, buying just one share in a FTSE 100 ETF gives you a stake in the fortunes of its 100 biggest companies immediately.

How they do it

ETFs track benchmark indices (baskets of stocks) in different ways.

Some use ‘physical’ replication, buying shares in all or a representative sample of the companies in an index. Under the bonnet, they tend to be very similar to the benchmark they track.

Physical ETFs thrive in large markets where the underlying shares can be bought and sold easily.

Occasionally, trading those underlying shares isn’t so straightforward. Step forward, ‘synthetic’ or ‘swap-based’ ETFs.

Instead of buying an index’s underlying shares, swap-based ETFs use a financial contract called a ‘swap’ between the ETF and another party – usually a bank – to receive the performance of the index. 

The bank issuing the swap commits to deliver the index’s performance to the ETF for a fee. This can help a swap-based ETF track an index extremely precisely, even in challenging markets.

While a physical ETF will look very similar to the index it’s tracking, the stocks held in a swap-based ETF basket generally look a bit different.

The value of the ETF is backed by the basket, that is wholly owned by the fund; the roll of the swap is simply to true-up the performance of the basket to the performance of the index being tracked.

Choosing the right ETF for you

The choice between ETF structures depends on a variety of factors. In certain markets, swap-based ETFs can offer a clearer advantage for those willing to embrace a bit more complexity and risk.

For example:

In the US, tax legislation currently allows European-domiciled swap-based ETFs that replicate returns of certain US equity indices to avoid paying withholding tax on any dividends paid by companies in the index. Physical ETFs, on the other hand, are subject to a 15-30% tax rate on these distributions. In this case, swap-based ETFs can outperform a physical ETF tracking the same index.

This can be very helpful given the US often makes up a large part of a balanced portfolio. You can benefit from this when investing in global equities too, because the US accounts for around 70% of an index like the MSCI World Index.

In China’s A-Share market, swap-based ETF’s benefit from a unique market dynamic that could boost your investment returns. This is due to limitations on how investors outside of China can access the market and because of this, swap-based China A-Shares ETFs have been able to generate a significant level of outperformance versus the indices that they track. The sheer number of hard-to-trade companies in most emerging markets indices makes them good candidates for swap-based ETFs too.

Closer to home, you might be able to reduce costs by using swap-based ETFs to access UK and European stock markets, as they are not subject to the Stamp Duty and Financial Transaction Taxes that are incurred by their physical counterparts when they buy the shares in the underlying companies.

These gains may be marginal, but they could lead to something much greater when they are all added together.

Things to be aware of

Investing in swap-based, rather than physical, ETFs could help you squeeze every last drop of performance out of your portfolio, without dramatically changing your risk/return profile.

Of course, investing always involves risks to your capital. The biggest risk with an ETF exposed to equity investments is the possibility that the companies that the fund is invested in lose money. This is true for both physical or swap-based ETFs.

The other concern with swap-based ETFs is what’s called ‘counterparty risk’ – the chance that a bank the ETF relies on for the swap contract fails to meet its obligations.

After all, if a counterparty does fail, the swap contract becomes worthless. At this point, the ETF would depend on the value of the assets held in its basket.

How does Invesco mitigate this counterparty risk?

1. We accept only quality securities in the basket
   We are very selective on what to accept into our baskets. The goal is always to include shares that are easy to sell if needed. The best ETF providers tend to build baskets that are at least as good, if not better, than what’s in the index. But they generally get all their performance from the swap, so they’re reliant on the banks for the returns.
   
   We’ve gone further by building baskets of high quality stocks and using them to deliver most of our performance. We only use the swap to fine-tune the results to ensure you get the index returns you’ve paid for, so we’re far less reliant on the banks.
2. We reset swaps frequently
   We reset swap agreements with our counterparties –settling the differences – if the owed value to either party exceeds a tight trigger level. This practice maintains stability and limits the amount any swap counterparty can owe the ETF.
3. We regularly assess and monitor swap counterparties
   At Invesco, we apply strict financial criteria to our counterparty selection.
   
   Continuous monitoring helps us to be confident that our chosen counterparties are financially healthy enough to meet their obligations. We have removed counterparties from our platform in the past when we had concerns about their credit outlook.
4. We use multiple counterparties to mitigate risk
   Invesco has the flexibility to choose a single counterparty or a range of them for our ETF swap contracts. Our preference is the latter, because using multiple counterparties helps us avoid over-reliance on a single bank.
   
   If an ETF has, let’s say, five banks providing the swap, if one of them fails, the financial impact should be much less than if we had only one counterparty to begin with.
5. Most of the fund value is in the fund basket
   Our swap-based ETF owns a basket of equities which accounts for the vast majority of the fund value. The only time that the fund has exposure to the swap counterparty is if the index being tracked performs better than the basket held by the fund.

Knowledge is power

Both physical and swap-based ETFs can contribute to well-diversified portfolios. To decide between them, start with where you want to invest, then look at your ETF options. If a swap-based ETF is available, there’s likely to be a good reason for that. Are there tax or cost advantages that could be passed on to you?

The rising popularity of swap-based ETFs shows that investors are willing to try different approaches in certain markets, if there’s a chance of better returns.

There’s no ‘one size fits all’ here. Understanding your options will help you make an informed decision when building your portfolio, in a way that best suits your preferences and goals.