Replication

An index fund can generate its return by investing in exchange-traded derivatives, usually exchange-traded index futures. This approach is most common for funds with leverage and funds with negative exposure, i.e. funds with the objective of generating a positive return when the underlying index goes down.

The most common type of exchange-traded derivative is exchange-traded index futures, with daily settlement of profits and losses between sellers and buyers. Exchange-traded futures thus have no formal value after this payment has been made. A fund manager therefore needs to invest the assets under management in instruments such as treasury bills or bank deposits.

NASDAQ OMX is the central counterparty that organises and is responsible for clearing and settlement of exchange-traded derivative transactions in Sweden. Consequently, NASDAQ OMX is the seller for all buyers and buyer for all sellers. Both the buying and selling parties thus have NASDAQ OMX as their counterparty. By serving as a central counterparty, the NASDAQ OMX reduces the market’s counterparty risk in derivatives trading and is therefore important for the stability of the financial system.

Xact´s leveraged ETFs generate their exposure using exchange-traded derivatives. The Oslo Stock Exchange is the central clearing counterparty for Xact Derivative Bull and Xact Derivative Bear. 

The objective of the ETF is to generate returns that reflect the return of the underlying index as closely as possible. In the case of physical replication, the manager must update the fund portfolio to keep securities at the same weight as the index. Consequently, the fund’s return can deviate from the index (“tracking error”) due to transaction costs that arise when the manager has to buy and sell securities in connection with index reweighting and other corporate events, as well as during dividend season, when dividends received are reinvested in the index to reflect it as closely as possible.

Replication with derivatives can eliminate deviations from the index to a greater extent. Here, the fund shifts the responsibility to the derivative counterparty to provide the fund with its exact index return. 

The ETF generates its exposure using OTC-derivatives

Funds that use synthetic replication can either invest in exchange-traded derivatives, usually futures, or in OTC-derivatives with specific counterparties. If the fund owns OTC-derivatives, these instruments are usually swaps. It is therefore common to call an ETF that generates its exposure using this type of instrument  a “swap-based ETF”.

The more complicated an exposure is to replicate, the more advantageous it may be to use synthetic replication to minimise transaction costs and tracking error. For a fund that tracks a commodity index where, for example, crude oil, grain and electricity are included, it would in principle be impossible to apply physical replication. In this case, derivative-based replication is the only way it is practically possible to generate the exposure.

Counterparty risk is the risk that a fund would be financially affected if a counterparty in one of the fund’s transactions should become insolvent and be unable to fulfil its contractual obligations.

In a fund with physical replication, the manager can opt to lend parts of the fund’s securities portfolio in order to increase the return through the loan premium received by the fund. Meanwhile, the fund still retains the market exposure to that which has been lent. The counterparty risk in these securities loans is the risk of the counterparty to which the fund lends the assets being unable to return them. To protect the unit-holders, the borrower in these transactions must therefore always provide adequate collateral for the value of the assets lent.

A maximum of 20 per cent of the fund’s assets can be lent in Xact’s ETFs with physical replication. Currently there is no lending.  

Counterparty exposure in synthetic replication

A fund that is compliant with the UCIT directive and achieves its exposure through OTC derivatives may not have a counterparty risk exceeding 10 per cent. Consequently, if a derivative that the fund has entered into has a positive value for the fund that is larger than 10 per cent, the derivative counterparty must provide securities or other assets as collateral. The 10 per cent limit is a minimum requirement and most ETF managers set requirements for collateral that are even higher. Funds that use funded swaps to generate their exposure often have collateral whose market value exceeds the counterparty exposure.

Every day a portfolio composition file (PCF) is published presenting all of the ETF’s securities and cash balances. Since the ETF reflects the performance of an index, the securities shown in the PCF will be the same as the securities included in the relevant index. The PCF provides the investor with daily transparency into the fund's holdings of equities or other securities, allowing the investor to avoid unwanted overweight in the same securities in other portfolios. The purpose of the PCF is also to show the securities and its share of the fund's total holdings to be delivered when a market maker wants to create or redeem units directly with the fund.