What's in Your ETF?

Have you ever wanted to really know what's in an ETF?  For those of you that may not dig to deep into the detail  this may be a good overview for you.  What you think you may be buying maybe isn't what you are actually buying.  Or, what you want to diversify to or track an index to might not be quite the fit you are looking for.  Case in point one of the largest ETF's the USO which tracks the prices of futures contracts of WTI (West Texas Intermediary) crude oil rather than the spot prices.  The funds NAV then becomes the change in the near-month futures contract price.  The issue becomes if you want to track actual prices this is not the vehicle to do so.  You also have the issue with oil prices between the premium paid for Brent vs. WTI.  


Here is the full article What's in Your ETF by David Pett at Financial Post a Canadian financial website.

• With the sovereign debt crisis throwing Europe’s banking sector into disarray, fears have swelled that banks underwriting the derivatives will become insolvent. Amid increasing counterparty fears, synthetic funds in Europe had redemptions of US$1.86-billion in October, while physically backed funds attracted US$3.11-billion, according to a report by BlackRock Inc., the world’s largest provider of ETFs.
• While many ETFs offered in Canada and the U.S. employ derivatives that carry counterparty risk, the number of swap-based ETFs on either side of the border are few and far between, with the vast majority holding physical securities to get market exposure.
• There are only two ETFs in Canada – Horizon Beta Pro’s S&P/TSX 60 Index fund (HXT) and Horizon’s S&P 500 Index ETF (HXS) – that use a total return swap structure in Canada to replicate stock indices. In the U.S., meanwhile, there are no synthetic ETFs and recently the U.S. Securities and Exchange Commission SEC decided that it would put a hold on any new exchange-traded funds seeking approval that planned to use derivatives to achieve their investment objectives.
• Howard Atkinson, Beta Pro’s CEO and chairman of the Canadian ETF Association, believes regulation is already extremely strong in Canada, and addresses the issues that have become a concern in Europe. He says swap-based ETFs can be attractive to investors because they are generally lower cost than physical ETFs, offer fewer tracking errors, and are taxed as capital gains with the added benefit that foreign investors are not required to pay withholding taxes.“Every decision you make is a trade off to some degree,” Mr. Atkinson said. Here you are trading off the remote possibility of a small loss due to counter party failure, for the almost certainty of better tracking, lower cost and better tax treatment.”
• In Canada, ETFs are regulated the same as mutual funds and like all Canadian investment funds, the counterparty to any total return swap must maintain a minimum credit rating equivalent to the following for each applicable credit rating service: DBRS rating of A, Fitch rating of A, Moody’s rating of A2, and/or an S&P rating of A. Swap-based funds are collateralized to a value of at least 90% of the fund’s assets, with all investor collateral placed in cash or cash equivalents.
• By contrast, Europe’s synthetic ETFs are also subject to the 90% rule but the collateral will typically be stocks, bonds and other liquid securities, and may not necessarily have anything to do with the index the fund aims to track. In other words, Japanese small-cap stocks could theoretically be used to collateralize an ETF of European large caps.
• The bigger concern is that the quality of that collateral is variable and may include things like unrated corporate bonds, which may be difficult to sell in the event of a market downturn, or worse sovereign debt from the eurozone’s periphery.  While the variable nature of many collateral pools has given some investors and regulators pause, for the most part, those concerns are only valid for the European market, said David Nadig, the director of research at IndexUniverse, an independent ETF news and research site.
• To the extent that there are concerns in North America, Mr. Nadig thinks investors should focus on one of three things: exchange-traded notes or ETNs, securities lending within funds, or leveraged and inverse ETFs, which are considered a separate category of ETFs in Canada and regulated as commodity pools.  ETNs are unsecured, unsubordinated debt notes that carry the largest potential counterparty risk, said Mr. Nadig, because the entire value of the note is based on the credit of the underwriting bank.
• “If that bank goes under, investors join the line of creditors with other bond holders,” he said. “Lehman Brothers, for instance, had two ETNs outstanding when it filed for bankruptcy. Although the products had minimal assets, anyone left holding those notes on the day the firm went bankrupt lost nearly all of their money.”  ETFs, along with many mutual funds may also actively engage in share lending activities, a process of loaning out the securities held within a fund as a way of generating extra profits for the shareholders.
• “Unfortunately, there is currently very little disclosure around this process, from how much of a fund is lent out at any given time to how the collateral posted in the transaction is invested,” he said. “Rules and regulations for securities lending are tougher in the U.S. than they are in Europe, leaving investors generally exposed to little more than overnight market-movement risk, but still, increased transparency would be beneficial.”
• Ultimately, counterparty risk is a cost of doing business, says Terry Shaunessy, a money manager at Shaunessy Investment Counsel, who uses ETFs to build portfolios for clients.  And like any type of investment, he thinks investors need to understand what they are buying and then weigh any risks, counterparty or otherwise, against their investment objectives.

WHAT’S IN YOUR ETF?

iShares S&P/TSX 60 Index Fund (XIU/TSX): With more than $11-billion is assets under management, XIU is by far the most popular of Canada’s 222 ETFs, which represents $41.3-billion in total assets. It is a physically-backed fund that invests in the stocks that make up the index that it is tracking.

Horizon Beta Pro’s S&P/TSX 60 Index Fund (HXT/TSX): One of only two synthetic ETFs offered in Canada, these funds do not buy the underlying securities directly, but use a total return swap structure that maintains 100% of its assets in cash as collateral for the swap which changes daily in value to reflect 100% of the positive or negative performance of the TSX 60. The sole counterparty is National Bank of Canada.

SPDR S&P 500 (SPY/NYSE) and Powershares QQQ (QQQ/NASDAQ): SPDR S&P 500 is organized as a unit investment trust, which prevents it from reinvesting dividends, holding securities not in the index such as futures or lending securities. The fund follows a full physical replication strategy, holding virtually every stock in the index. QQQ is similarly structured, holding all of the stocks in the Nasdaq 100.

Claymore U.S. Fundamental Index ETF C$ Hedged (CLU/TSX): This fund employs a physical replication strategy similar to XIU, in this case buying the underlying shares of the FTSE RAFI U.S. 1000 index. The fund then engages in a forward contracts with a counterparty to hedge it’s U.S. dollar exposure back to Canadian dollars. Any agreements are guaranteed by the exchange or clearinghouse that hosts the trade. Tracking error risk can occur with some currency-hedged products that hedge once a month because new inflows are not accounted for.

Horizons Beta Pro NYMEX Crude Oil Bear Plus ETF (HBP/TSX): This fund generated $147-million in net sales this past October, second only to XIU. Like most leveraged and inverse products, it relies on derivatives to gain exposure to the market. In Canada, leveraged products typically use Canadian stocks as collateral, with the counterparty involved in the construction of the equity basket to ensure the most liquid assets are being used.

Ultra S&P 500 ProShares (SSO/NYSE): This U.S.-based leveraged fund holds on to its cash collateral for index swaps it uses and therefore their principal faces no counterparty risk. The only danger from banks and other financial counterparties collapsing is that the fund may lose part of its promised return.

United States Oil (USO/NYSE): tracks the prices of futures contracts of WTI crude oil. The fund’s net asset value, thus, isn’t tied to spot prices, but rather the change in the near-month futures contract price.

Full disclosure I own shares of USO in my personal accounts