Investors in ETF Securities’ exchange-traded commodity (ETC) products had a nasty shock last week. The near-demise of insurance giant AIG saw a large number of the group’s ETCs, which track the price of various commodities, suspended from trading. This happened when market makers, who hold securities for the short period while a trade is being finalised, became concerned that AIG wouldn’t be able to make good on its commitments.
Following the Federal Reserve’s $85bn bail-out of AIG, the ETCs have returned to trading as normal. However, the episode has raised the troubling question of counterparty risk (the danger that the firm on the other side of the trade can’t meet its contractual obligations) in relation to these products. So what does this mean for exchange-traded funds (ETFs) in general?
Exchange-traded products
Firstly, a quick re-cap. ETFs, together with ETCs, which are themselves a form of exchange-traded note (ETN), fall under the collective banner of exchange-traded products (ETPs). These combine the characteristics of individual shares with those of a collective fund by tracking a group of stocks, or an asset such as gold.
ETPs can be traded through a stockbroker at any time in any amount, and are low cost. Management fees are generally around 0.5%, compared with the 1% charged by most trackers. They can also be held in an Individual Savings Account (Isa) or Self Invested Personal Pension (Sipp). But it’s important to appreciate the differences between the various types of ETP.
Firstly, ETFs. There are two main kinds. Traditional ‘in-specie’ ETFs, otherwise known as ‘cash-based’ or ‘physical’ ETFs, broadly hold the underlying securities of the index they track. Their appeal is that they’re highly transparent. Should the fund provider fail, the investor has direct recourse to the fund’s ring-fenced pool of underlying assets.
US ‘physical’ ETFs must hold 100% of the underlying securities of the index they track, says Sophia Greene in the FT, while in Europe “they can also use derivatives, but must hold a minimum of 90% of the fund as collateral”. So any counterparty loss is limited to a maximum of 10% of the fund value. Lyxor ETFs come under this category, as do Barclays iShares’ US and London-quoted ETF range.
‘Swap-based’ ETFs
‘Swap-based’ ETFs, on the other hand, invest in derivatives contracts, which are generally offered by third parties such as brokerage firms and banks, to provide index exposure. Funds hold baskets of securities (which can be different from the underlying index securities) and an index swap. Counterparty risk is limited to a maximum of 10% of the value of the fund per counterparty under the EU’s Undertakings for Collective Investments in Transferable Securities (UCITS) rules. The investor has recourse to the basket of securities if the fund issuer fails. Db-trackers has confirmed that its products are swap-based.
Then there are ETNs. These aren’t actually funds – although ETNs also promise to pay the returns of a benchmark index – but ‘note’ holding debt instruments. Investors are fully exposed to the counterparty risk of the note issuer suffering a credit rating cut, or, indeed, going bankrupt. In that event, ETN values will be badly eroded, although this risk is sometimes reduced through collateral or guarantees.
ETCs are a special type of ETN linked specifically to commodities or commodity indices. Some are backed by physical assets (such as precious metals), reducing the risks, whereas others are backed by the issuer or a guarantor.
What does this mean for you?
The bottom line is that unless you invest in a ‘physical’ ETF that holds the actual stock, such as a tracker fund or investment trust, there’s a degree of counterparty risk. To be clear, the risk on ‘swap-based’ ETFs is low.
At a maximum exposure of 10% per counterparty, a lot of third parties would have to be in trouble to create a serious problem. It is worth checking who the counterparty is before you buy – but overall, we think investors can buy ETFs with confidence. They are among MoneyWeek’s favoured ways to buy into any market.
In the case of ETCs, the immediate AIG situation seems to be dealt with, although we have had complaints about spreads on some of the products. According to Nick Brooks at ETF Securities, this issue should go away “sooner rather than later” and comes down to market makers gearing back up to trade in ETCs. The company is also trying to get full 100% collateral backing from AIG for ETCs, which should offset the counterparty risk. The products backed by physical assets, such as gold and silver, remain unaffected, as are those oil securities backed by Shell.
Investors should always be careful when buying directly into volatile areas such as commodities and shorting, but the last few weeks should remind us all that there are extra, unexpected risks that can rear up when financial markets are this volatile. ETCs remain convenient ways to access hard-to-reach markets, but investors should be clear that they come with risks beyond those related to the price of the underlying commodities.
Category: Investing in Gold