Date: August 14, 2017
ETFs can be structured differently to track the same underlying index. For example, some ETFs replicate the index by investing in the index’s component stocks. Others may invest in a representative sample of stocks from the index they are designed to track.
Some ETFs may use other more sophisticated instruments like swaps and participatory notes in addition to holding a basket of representative stocks or collateral. This may be because they wish to track the underlying index more efficiently or because it is not possible for the ETF to invest directly in the index’s component stocks.
However, this exposes the ETF to counterparty risk from the swap counterparty or participatory note issuer. This means that in the event of bankruptcy or insolvency of the counterparty, the ETF may incur losses and the extent of loss will depend on fund’s exposure to the swap counterparty. For example, UCITS III compliant ETFs(1) are allowed to use derivatives (including swaps), although they must limit their exposure to a single counterparty to 10% of its net asset value (NAV), most commonly via the posting of collateral. In other words, the fund is limited to the losses that are related to the default of the swap counterparty, to a maximum of 10%, should the collateral maintain its value after a default. There are also other ETF structures which require posting of collateral by the swap counterparty to mitigate the extent of loss, should the counterparty default.
(1) UCITS III is the regulatory regime for funds in Europe. UCITS refers to undertakings for collective investment in transferable securities.
TIP: Always find out how the ETF you are considering works. Remember that not all ETFs have the same structure and level of complexity.
- Read the “Investment Approach” and “Risks” portions of your prospectus for information on the various risks of the specific ETF you intend to invest in. Note that the risk elements may differ greatly between ETFs depending on their structure.
- Consider if the ETFs structure and risk profile suit your risk appetite and investment time horizon.
- Do not invest in an ETF if you do not understand or are not comfortable with the structure.