This extract explains that other than buying proportionately the underlying shares of the indice it is tracking, an ETF sponsor has two other ways of constructing an ETF. The sponsor could mimic the index by buying only a sample of the stocks. This is called "representative sampling". If it gets the sampling wrong, the ETF will not track the index that closely: in the jargon, the tracking error is greater.
A sponsor could also replicated an index through derivatives usually via swaps. This means that the ETF is a structured product. Now after the Minibonds, and HN5, Jubilee and Pinnacle notes debacle, structured products have a bad name. But ETF sponsors claim that they do everything they can to mitigate the risks. And while the stock exchanges that list these EFTs legally have no liability if these EFTs go wrong, their reputations are on the line if structured ETFs go bust.
From a 2009 BT article republished by the CPF Board. Link to article is provided below
But as ETF penetration grows, investors should be aware that not all are created alike. While most ETFs are designed to track an underlying index, there are actually two to three types of structures, each with advantages and risks.
The first type is what most investors would be familiar with - ETFs that replicate an index by physically investing in the index's component stocks. SSGA's streetTRACKS STI is an example of this. Then there are ETFs that replicate the index through a 'representative sampling'. As the term indicates, this takes a sample of stocks that approximates the index's performance.
Then there is the synthetic structure, where index performance is replicated through derivatives, usually a swap arrangement. This is typically done for markets where access may be difficult and liquidity poor. Those listed here by Lyxor and Deutsche Bank's db x-trackers series are swap-based ETFs. ETFs that track the China A shares indices on the Hong Kong exchange also do so through derivatives.
Cash-based ETFs, which seek to buy an index's underlying shares or a sampling of shares, offer the comfort of transparency and are relatively easy to understand. The drawback is that there may be deviations from the index, which in industry parlance is called a 'tracking error'. This occurs when weightings of underlying stocks shift, or the components are changed and the portfolio needs to be rebalanced, for instance. Performance between ETFs that track the same index may vary. The performance of DBS STI ETF, for example, has lagged the FS STI Index by more than 2 percentage points.
Managers of cash-based ETFs may lend out the securities. While this generates revenue for the fund, it incurs counterparty risks. SSGA says it does not engage in securities lending for its Asian ETFs.
Swap-based or synthetically structured ETFs offer the advantage of a tracking error that's virtually zero, says head of db x-trackers for Asia, Marco Montanari. In a swap based ETF, the fund holds a basket of securities which may be completely unrelated to the index it is linked to. It enters into a swap agreement with a counterparty where the latter undertakes to deliver the performance of the index to the fund. The fund on its part will deliver the returns of its basket of securities.
Such an arrangement, of course, also raises the spectre of counterparty risk which loomed large through this recent credit crisis. A case in point are the London-listed commodities funds of ETF Securities, which had AIG as a counterparty. As AIG teetered on the brink last year, the funds plunged in value and were suspended from electronic trading.
Yet another issue is that there may be little transparency on the types of securities held as collateral for the swaps, which may themselves plunge in value in a crisis. There is of course no guarantee on the value of the collateral.
There are ways, however, to mitigate the risks. European funds, such as those structured under the UCITS III umbrella, are subject to a cap of 10 per cent in terms of counterparty exposure. UCITS refers to the authorisation regime for funds in Europe.
Managers themselves can go the extra mile. For db x-trackers, Deutsche Bank as the ETFs' swap counterparty has set up an account with the fund custodian in which cash and securities are pledged to the account. The collateral is subject to concentration limits. There is for instance a 4 per cent cap on any single security.
Full article, courtesy of CPF Board
http://www.cpf.gov.sg/imsavvy/infohub_article.asp?readid={460637084-2739-872464179}