Investors are rightly interested to know about the underlying assets held inside their investment products. Buying individual stocks gives you potential access to dividends and capital growth the company generates. But what about managed funds and ASX traded Exchange Traded Funds (ETFs) – what do they hold?
We look further into this issue in this week’s BetaShares Academy post.
The current regulatory position is that, to be called an “ETF”, the fund must hold assets which seek to track or follow the performance of a published index (such as the S&P/ASX 200 index) or asset (such as gold bullion).
Apart from these parameters, ETFs can be classified into two broad categories – physical or synthetic.
Physical or synthetic – what’s the difference?
A “physical” ETF holds the underlying securities or asset to replicate the index or asset class. For example, in the case of the BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ), the fund will actually hold the different shares that make up the index, replicating the index weighting of each individual stock.
Top 10 Holdings of BetaShares FTSE RAFI Australia 200 ETF as at 26 May 2014
In comparison, a “synthetic” ETF will not hold the underlying asset or constituents of the index being tracked, and instead will use a derivative (which is traded “over-the-counter” or directly between two parties rather than on an exchange) to obtain synthetic exposure to generate returns for the investor.
In Australia, if an ETF holds such derivatives to a material extent, it is considered a “synthetic” ETF and must include “synthetic” in its name. However, the level of counterparty exposure in an Australian ETF (the amount owed to the ETF by the other party to the derivative) must be limited to no more than 10% of the net asset value of the fund at any time. In practice the counterparty exposure is usually substantially less than that. This maximum level of counterparty exposure marks an important distinction between synthetic ETFs in Australia compared with global markets – the 10% rule does not necessarily apply outside of Australia.
One of the reasons for limiting counterparty exposure is to reduce counterparty risk – the risk that the other party to the derivative defaults on its obligations.
Requiring the use of the “synthetic” label is to ensure investors are made aware the fund is obtaining its investment exposure via derivatives.
Why use synthetic structures?
BetaShares has always sought to adopt the most appropriate structure to deliver investment returns. As a result virtually all of our products use ‘physical’ structures. For example, our gold ETF is backed by physical gold bullion, our equities products hold shares and our Cash product is backed by at-call cash.
However, when it’s hard (or impossible) to hold and store some types of commodities (eg live cattle, grain, oil, etc), in order to create ETF exposure to these assets, the BetaShares commodity ETFs will use derivatives.
Importantly however, the underlying asset backing to these products is cash – so there is still a tangible asset backing the ETF. This type of ETF invests all of its assets into cash and obtains exposure to the commodity price via a swap agreement with a large financial institution.
When purchasing ETFs, investors should consider the structure of the fund and how it is generating returns. If all else fails, don’t hesitate to contact the ETF issuer, who can help you better understand the underlying ETF structure.