Different structures

ETFs can have different structures, which makes it important that you understand the differences between them before you invest, so that you can find the right fund for your personal investment objectives.

The two major types of ETF are cash-based and swap-based.

Cash-based ETFs

A cash-based ETF generally buys all of the securities in the underlying index and holds them as fund assets. In some cases, when it is not considered cost-effective to buy all of the securities in the index (for example when an index is not very liquid), then a process known as ‘optimisation’ is used. This involves buying a portion of the securities within the index and using these to track the index’s performance. For example, in the case of the MSCI World, the iShares ETF holds around 700 securities whereas the index holds more than 1800 constituents.

Swap-based ETFs

A swap-based ETF uses total return index swaps to replicate an index’s performance.
A swap is an agreement between two parties, in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. What this means in essence is that when you buy a swap-based ETF, you are buying the performance of the index, not the physical securities it contains.

Swap-based ETFs can, in some instances, provide a more tax-efficient investment. They can also be a good way of gaining exposure to markets that cannot be accessed through cash-based funds, such as commodities. However, swap-based funds are generally considered a slightly riskier investment when compared to their cash-based equivalent.

Swap-based ETFs remain mutual funds, so do not have issuer-related risk. They are exposed to counter-party risk as they can buy derivatives, lend securities and enter swap agreements for the fund. Counter-party risk is the risk to each party that enters into a contractual agreement, that the other party (or counter-party) will not live up to its contractual obligations

However, in the case of UCITS-compliant swap-based ETFs, the counterparty exposure to the swap cannot exceed 10% of the fund’s net asset value. UCITS is an EU Directive which establishes a common regulatory regime for Undertakings for Collective Investment in Transferable Securities. It is a set of regulatory guidelines for funds that allows compliant fund structures to be marketed throughout the European Union.

Other exchange traded products

There are other exchange traded products available on the markets such as Exchange Traded Notes (ETNs). ETNs are debt instruments. ETNs are not funds, but they do share several characteristics, as both structures are usually linked to the return of a benchmark index and trade on exchange. Special types of ETNs include Exchange Traded Certificates and Exchange Traded Commodities, the latter are linked to physical commodities or commodities indices. Some ETNs are backed by physical assets, whereas others are backed by the issuer or a guarantor.

As ETNs are notes, ETN investors have direct counterparty exposure to the issuer of the note or to any third party that is guaranteeing the security’s performance. The ETN structure allows for more flexibility in issuing products (i.e. on single commodities and securities).