Exchange-traded Funds

Mitch Kosev and Thomas Williams*

The exchange-traded fund (ETF) industry has grown strongly in a relatively short period of time,
with the industry attracting greater attention as it grows in size. The original appeal to investors of
these products was their simplicity, low-cost diversification benefits and ability to trade intraday.
While this is still broadly the case, the evolution of the industry has resulted in a greater variety
of ETFs becoming available to investors and improved accessibility to different asset classes.
However, ETFs have also become more complex in the structure and types of strategies they
employ in generating returns. These developments have created new opportunities and challenges
for investors, market participants and regulators.

Introduction an ETF may hold the stocks underlying a benchmark

equity index. However, some use derivatives such
This article examines a relatively recent innovation
as futures, forwards, options and swaps to simulate
in financial markets, exchange-traded funds (ETFs).
the return from physically holding the asset, and are
ETFs are investment vehicles that are listed on a stock
referred to collectively as synthetic ETFs. ETFs may
exchange and provide investors with the return of
also use some combination of the two strategies. The
some benchmark, such as an equity index. The appeal
differences between physical and synthetic ETFs are
of ETFs is twofold: a simple, low-cost means of gaining
discussed in greater detail in the next section.
a diversified portfolio and the capacity for intraday
trading. They also offer investors the ability to invest ETFs are similar to managed funds in that both can
in a range of asset classes which may otherwise be provide broad exposure to an underlying asset.
inaccessible or prohibitively expensive, including However, there are a number of key differences
emerging market equities and commodities. ETF
investment has grown strongly in recent years, with Graph 1
global assets under management well in excess of Global ETFs*
Assets under management
US$1 trillion (Graph 1). Investment in these securities US$b US$b

is not without risks, however, and the industry’s 1 200 1 200

rapid growth has attracted increased attention from
1 000 1 000
regulators.
800 800

The ETF Industry 600 600

ETFs are securities backed by a pool of assets, the
400 400
return on which is expected to track a specific
benchmark as closely as possible. Generally, an ETF 200 200

will physically hold the underlying assets. For example, 0 0

1994 1998 2002 2006 2010
* Excludes exchange-traded commodities
* The authors are from International Department. Source: BlackRock

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between the two investment vehicles. While investors Most equity ETFs focus their investment in equities
can trade ETF shares intraday on a stock exchange, from a specific country or region (Graph 2). Of these,
transactions in managed funds occur, at most, once the number and size of ETFs that invest in emerging
a day. ETFs also tend to have lower management fees market equities have grown strongly, with assets
and brokerage costs because an ETF will not generally under management of nearly US$200 billion in
buy or sell its underlying assets to create shares (see 2010 from less than US$1 billion in 2001. In some
Box A for details on how ETF shares are created and cases, emerging market ETFs are the only way that
redeemed in the primary market). Furthermore, ETFs foreign investors can access these markets. Growth
have tax advantages in some jurisdictions, including has also been strong in a range of equity ETFs that
the United States, because a managed fund may have allow investors to invest in specific equity market
to sell its holdings to meet redemptions (potentially sectors, such as financial or technology indices,
creating a taxable capital gain), while an ETF does not. and style-specific investments, such as ‘growth’ or
Unlike investment in managed funds, ETF investors ‘small-cap’ stocks.
cannot buy or sell shares directly from the issuer, but ETFs that track fixed income returns represent 15 per
instead must make transactions via a stock exchange. cent of total ETF assets under management. Fixed
There are around 2 700 ETFs globally, with strong income ETFs provide investors with access to a range
growth in total assets under management over the
Graph 2
past decade (Table 1). Those domiciled in the United
Equity ETFs by Type of Investment
States account for around US$1 trillion, or 70 per cent, As at end February 2011
US$b No
of global ETF assets, with trading in US ETFs equivalent
to around one-quarter of aggregate turnover in US Number of ETFs
(RHS)
equities. In Europe, ETFs have attracted investment of 600 600

approximately US$300 billion, while those domiciled

in Australia have assets of around US$4 billion.
400 400
Total assets
The majority of ETFs track equity indices. Globally, (LHS)

equity ETFs have around US$1.1 trillion in assets under

200 200
management and account for around three-quarters
of total ETF investment. Equity ETFs allow investors to
buy a single security that aims to replicate the return of 0 0
Country Region Sector Style Global
an entire portfolio of stocks such as the S&P 500 index. Sources: Bloomberg; RBA

Table 1: Global ETF Investment by Type of Asset

As at end February 2011

ETF type Number of ETFs Assets under Per cent of total

management assets
US$b
Equity 1 895 1 067 74.0
Fixed income 365 217 15.0
Commodity (a)
358 147 10.2
Other 86 12 0.8
Total 2 704 1 442 100.0
(a) Includes exchange-traded commodities.
Sources: Bloomberg; RBA

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of bond and money market investments, including Graph 3

government and corporate debt, as well as broad Commodity ETFs*
US$b %
aggregates, such as investment-grade bonds and
high-yielding securities. The greatest proportion of Assets under management
(LHS)
investment is concentrated in government bonds, 120 60

comprising around 30 per cent of fixed income ETF

assets.
80 40
Per cent of total
ETFs that track commodities represent 10 per cent commodities investment
(RHS)
of total ETF assets under management and
40 20
have become one of the most popular means
of gaining exposure to commodity prices.1
Commodity ETFs represent a more cost-effective 0 0
2007 2008 2009 2010
means of accessing this asset class than alternative * Includes exchange-traded commodities
Sources: Barclays Capital; RBA
investment vehicles. Investment in commodity ETFs
has grown from around US$40 billion in 2008 to
around US$150 billion in 2010 and now accounts traded commodities (ETCs).3 ETCs are technically
for 40 per cent of total commodities investment debt instruments linked to the value of an underlying
(Graph 3).2 Like futures, holding commodity ETFs portfolio of assets (i.e. secured, undated, zero coupon
does not require the investment in infrastructure notes). Despite having different regulatory and
needed to buy and store the physical commodity. disclosure requirements, both commodity ETFs
Moreover, ETFs require a small minimum outlay and and ETCs are similar in the way they trade and both
are more liquid than other forms of commodities need to be taken into account in forming a complete
investment. For example, one crude oil futures picture of the size of the commodity exchange-traded
contract represents an interest in 1 000 barrels of oil product market.
and requires an initial investment (margin) of around ETFs that are designed to expand investors’ allocation
US$7 000. In contrast, the price of one share in the opportunities by providing exposure to alternative
synthetic United States Oil Fund ETF is currently asset classes and investment structures are becoming
around US$40. increasingly common. Notable examples include
Setting up exchange-traded instruments for ETFs attempting to deliver hedge fund performance
commodities is slightly more complicated than is the and those that track currency returns. There is
case for equities. Regulation and the illiquid nature of also a growing number of ETFs, particularly in the
many commodity markets mean that in some cases United States, which use leverage (predominantly
commodities cannot be structured in the same legal through derivatives) in an effort to enhance returns.
form as traditional ETFs. This is because investment These include leveraged ETFs providing specified
companies have a restricted range of assets in multiples – often two or three times – of the daily
which they can invest and must also meet minimum return of an underlying asset. Others, known as
requirements for diversification. Therefore, most inverse ETFs, aim for the opposite (or in the case of
products in Europe are legally set up as exchange-
3 There are also products tracking a range of asset classes known as
exchange-traded notes (ETNs). ETNs are typically unsecured debt
instruments issued and held on the balance sheet of large financial
1 This figure includes exchange-traded commodities. institutions (typically investment banks or asset management firms).
2 Total commodities investment includes assets under management in In contrast, the assets of ETCs (which are also debt instruments) are
commodity exchange-traded products, commodity index funds and often held by a ring-fenced special purpose vehicle to protect against
commodity-linked medium-term notes. default risk.

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leveraged inverse ETFs, multiples of the opposite, such In Europe, however, regulatory changes have seen the
as negative two or three times) return and are used to use of synthetic ETFs grow rapidly, with such funds
gain from falling prices or to hedge existing portfolio accounting for almost half of total ETF assets under
positions. A small number of ETFs are also available management. The advantages of a synthetic strategy
where the fund actively manages its investments, can include lower cost, improved accessibility to
with some attempting to make higher returns than particular asset classes and investments (including
would be earned by passively tracking the return on emerging market shares) and greater accuracy in
an asset. delivering the targeted return. That is, a synthetic
strategy can reduce tracking error as the ETF is
Physical versus Synthetic ETFs contractually guaranteed to receive the same return
as the underlying asset. For example, physical equity
As mentioned previously, there are two common
ETFs must rebalance their constituent holdings
strategies employed by ETFs to achieve the target
each time the target index is reweighted, while
return: physical and synthetic. Physical ETFs hold
for a synthetic ETF using swaps, this becomes the
the assets underlying a particular benchmark. For
responsibility of the swap counterparty. A synthetic
example, an equity-based ETF can hold all or a
strategy may also be necessary when physical
sample of the stocks underlying a benchmark equity
replication is not possible (e.g. an ETF may be unable
index. The advantages of a physical replication
to directly access Chinese shares). However, the
strategy include greater transparency of the ETF’s
structure of synthetic ETFs can be complex and may
asset holdings and more certainty of entitlement for
lack transparency, with the use of derivatives also
investors should the ETF be liquidated. Restrictions
exposing the ETF to counterparty risk. Box A discusses
on the use of derivatives in some regions, particularly
synthetic ETFs in more detail.
in the United States, have also contributed to the
continued dominance of physical replication. Most Around four-fifths of investment in commodity ETFs
ETFs in the United States and Asia Pacific region occurs through physical replication (e.g. buying
use physical replication to track their underlying and storing gold bars to track the spot price of
benchmark (Graph 4). gold). Compared with equity ETFs, where synthetic
strategies tend to provide lower tracking error, only by
Graph 4 holding physical commodities can these ETFs closely
ETFs by Region* track the return on the spot price of the underlying
Assets under management, as at end December 2010
US$b US$b commodity (less fees).4 Investment in physically
 Synthetic backed commodity ETFs is concentrated in precious
 Physical
800 800 metals, which are ideal for this structure because they
have low storage costs relative to their value, are not
600 600 perishable and have futures price curves which are
frequently in contango (i.e. the futures price for the
400 400 closest-to-maturity contract is lower than for the
next month). Gold accounts for around 80 per cent
200 200 of investment in physically backed ETFs. The large
increase in investment in gold ETFs during the financial
0 0 crisis has been attributed to gold’s safe-haven status
Asia Pacific Europe United States
* Excludes hybrid ETFs (Graph 5). The popularity of these products has seen
Sources: BlackRock; RBA

4 The return on commodity ETFs that use synthetic replication can

differ substantially from the return on the spot price of the underlying
commodity for reasons discussed in more detail below.

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Graph 5 Graph 6
Physical Commodity ETFs* Synthetic Commodity ETFs*
Assets under management, by commodity Assets under management, by commodity sector
US$b US$b US$b US$b
 Industrial metals
 Other  Precious metals
 Silver  Agriculture
 Gold  Energy
 Commodity indices
80 80 20 20

40 40 10 10

0 0 0 0
2007 2008 2009 2010 2007 2008 2009 2010
* Includes exchange-traded commodities * Includes exchange-traded commodities
Sources: Bloomberg; RBA Source: Barclays Capital

the number of physical commodity ETFs rise, and the Benefits and Risks of ETF
first products backed by holdings of base metals such Investment
as copper were launched late last year.
ETFs can offer a number of benefits to investors,
Apart from precious metals, and to a lesser extent including: a simple, low cost means of diversification
base metals, commodities are generally both costly and the ability to be bought and sold intraday. As ETFs
and difficult to buy and store. This has led a number trade like ordinary shares they can often be short sold
of commodity ETFs to use synthetic replication to (where a security is borrowed and then sold, allowing
achieve their return objectives. A typical strategy the seller to profit from falling prices) and investors
involves the ETF purchasing closest-to-maturity can use risk-management strategies such as limit and
futures contracts and rolling them prior to expiry. If stop-loss orders in making trades. They also enable
the price of the futures contract for the next month investors to invest in a range of asset classes, including
is lower than that for the current month – that is, the emerging market equities and commodities that
market is in backwardation rather than contango – might otherwise be difficult to access. Further, ETFs
then the roll return is positive. As a result, investing in a tend to be a cost-effective method of investing,
synthetic commodity ETF can generate a return above with expenses generally lower than similar products
the return from holding the physical commodity. The offered by managed funds.
opposite occurs when the market is in contango. In
However, ETF investment does not come without
this situation the roll return is negative and the return
risks and ETFs are increasingly attracting the attention
from investing in such a synthetic commodity ETF will
of regulators. Generally, concerns about ETFs stem
be lower than the return from holding the physical
from liquidity and counterparty risk and, in some
commodity. Because of this, most investment in
cases, complexity and a lack of transparency. An ETF’s
synthetic commodity ETFs is in energy commodities
liquidity on the primary market is linked to the liquidity
and broad commodity indices (with large weights
of the underlying assets. In addition, some ETFs may
given to energy), since the futures curves of these
not trade actively intraday and market volatility can
commodities have historically spent most of the time
inhibit liquidity for ETFs if large ETF traders withdraw
in backwardation (Graph 6).
from the market or there is difficulty in creating new
ETF shares. Events such as the ‘flash crash’ of the

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S&P 500 on 6 May 2010, where ETFs were severely

affected by the sudden fall in US equity prices, have
also raised questions as to their potential contribution
to heightened market volatility as well as their broader
impact on market structure.
Counterparty credit risk is an issue for synthetic
ETFs, particularly those using swaps (see Box A), and
those lending the securities underlying the ETF to
generate additional income. Collateral arrangements
and swap resetting are typically used to address
this and attempts have been made by a number of
swap-based ETF providers to increase the frequency
of swap resetting, with some providers also engaging
multiple swap counterparties.5 There has also been a
shift by some ETF providers towards a swap structure
where collateral is pledged to the fund. However,
this may not guarantee immediate access to the
collateral in the event of a counterparty default
and highlights the importance of sound collateral
management practices.
Finally, there is the issue of complexity and
transparency. Part of the appeal of physical ETFs is
their simplicity, and some investors are attracted
by the fact that their interest in the fund is backed
by the assets underlying the benchmark. However,
there has been significant growth in the number of
ETFs with complicated structures using derivatives
to create leverage, as well as funds based on opaque
performance benchmarks. In some cases, the exact
structure and types of derivatives being used by ETFs
are unclear. These more complex investments can
vary considerably in both their structures and the risks
they present.

5 Swap resetting occurs when a payment is made by either the

counterparty or ETF to match the value of the ETF’s holdings to
changes in the value of the asset being tracked.

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Box A
How Do ETFs Work?

The Creation and

Redemption Process
ETFs are typically structured as open-ended
companies, which allows the number of shares in
the fund to vary over time. Unlike managed funds,
however, retail and institutional investors must
purchase ETF shares on a stock exchange and cannot
buy or sell shares directly from the fund. Before an
ETF can commence trading, the fund undertakes
a process of creation in the primary market
(Figure A1). An ETF will create shares in large blocks
(typically of between 25 000 and 200 000 shares),
referred to as ‘creation units’, which can only be
purchased by Authorised Participants – usually Creations and redemptions of ETF shares occur on
market-makers or institutional investors that must an on-going basis and are priced at the net asset
be registered with the ETF. To purchase a creation value (NAV) of the assets held by the fund. ETFs
unit in an ETF tracking an equity index, an Authorised are required to publish daily information about
Participant does not generally use cash but instead the fund’s holdings of securities and NAV, as well
transfers a portfolio of securities to the ETF (usually as the composition of the portfolio needed for
comprising the shares underlying the index it is creations and redemptions. On the secondary
tracking). market, ETF prices are determined through intraday
trading on the stock exchange, but should usually
Once the creation unit is transferred to the
mirror the ETF’s intraday NAV. Because ETFs trade
Authorised Participant, it can be broken up and sold
on the stock exchange, their prices are subject
on the secondary market. Only at this point can retail
to fluctuations in supply and demand, which may
and institutional investors buy and sell ETF shares
cause the ETF to trade at a premium or discount
via a stock exchange. Authorised Participants can
relative to its NAV. However, these deviations are
also dispose of their shares by selling them back to
usually small, with any sufficiently large opportunities
the ETF through a process of redemption, which
exploited by arbitrageurs. Dividends are either paid
is essentially the reverse of creation. Cash may be
to investors periodically or reinvested into the ETF.
used during the creation and redemption process
for those funds using derivatives to track their
benchmark.

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The Structure of a Synthetic ETF will transfer the complete performance of the target
benchmark (e.g. the return on the German DAX index)
ETFs may use any number of derivatives, including
to the ETF, including both capital gains and dividends.
forwards, futures, options and total return swaps to
While variations exist, in practice, this can be done in
deliver synthetic exposure to a target benchmark.
three stages.
Swap-based structures are commonly used by
synthetic equity ETFs to achieve exposure to the To create shares, an Authorised Participant uses cash
underlying index (Figure A2). Total return swaps are rather than a portfolio of assets to buy a creation unit
an agreement between two parties to exchange (Stage 1). The ETF then invests the cash in a basket
one type of return for another. This involves the fund of securities which may not be the same as the asset
engaging a swap counterparty, which will be paid a being tracked by the ETF. The securities held are
stream of cashflows. In return, the swap counterparty typically liquid, high quality assets and form the ETF’s

Figure A2
An Example of a Swap Replication Strategy
Primary market

Stage 1 Stage 2 Stage 3

Swap
counterparty

Return on
collateral

Collateral Variable
rate cash
basket flow

Cash

Variable rate
Cash cash flow
Authorised Swap
ETF
participant Index return Index return
counterparty

ETF
Cash
shares

Secondary market
Cash Retail/
Stock
exchange institutional
ETF shares investors

Source: RBA

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collateral. The return on this collateral basket is then

swapped for a stream of cash flows based on a variable
rate such as LIBOR (Stage 2), which the ETF uses to
invest in a second swap paying the return on the
target asset (Stage 3). Often the counterparty to both
transactions is the ETF’s parent financial institution
(typically an investment bank or asset management
firm). While some swap-based ETFs lack transparency
regarding the ETF’s exact structure, holdings and
potential losses in the event of counterparty default,
disclosure of this information is improving. For these
ETFs, counterparty exposure is managed by the fund
regularly resetting (typically daily) the value of the
swap.
Another type of swap structure has also evolved
in response to investor demands for greater
transparency. This involves the ETF investing directly in
a swap, rather than a basket of securities, to return the
target asset performance. To provide collateral to the
ETF, the swap counterparty will enter an agreement
to pledge assets to the ETF. Some ETFs have begun
publishing information about the composition of
the collateral held in the fund’s name. The pledged
securities are held in a ring-fenced structure with a
custodian and are not available for securities lending.
The collateral is only accessible by the ETF in the event
of a credit default by the counterparty. R

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