Evercore Pan-Asset on Exchange Traded Funds Continued, www.pan-asset.co.uk

Jan. 15, 2009 - PRLog -- How do ETFs Track their Index

ETFs track their underlying indices in one of three ways:
Replication – this means replicating the index exactly by buying exactly the same investments as those in the index in exactly the same proportions, re-balancing whenever the index is rebalanced.

Optimisation – this means seeking to track the index returnby investing in a subset of the index constituents whose returns are judged likely to match those of the index as a whole.

Synthetic Replication – this means buying investments that may or may not be index constituents and entering into a “swap” transaction with the ETF’s sponsoring investment bank to swap the return on these investments for the return of the index. In other words, the ETF transfers to the swap counterparty the risk that the investments may not track the index and is assured of being able to deliver the index return to its own investors.

Replication may seem the most natural method of index tracking but it is not always practical. For example, in the UK it is possible to replicate the FTSE 100 Index which is made up of the biggest 100 companies since their shares are liquid and are easy to buy in the required quantities. However, this is less true of the broader and more representative FTSE All-Share Index which has nearly 700 constituents, many of which are comparatively illiquid smaller companies. Even optimisation is difficult in this case, so the ETFs that track the FTSE All-Share Index use replication.

Swaps are a well-established financial tool. However, the synthetic replication method is a form of financial engineering and introduces an element of counterparty risk should the counterparty to the swap default. This could put a small element of the ETFs assets at risk so it is important that the counterparty is strong and there is a regulatory obligation that an ETF’s swap counterparty risk should never exceed 10% of its net asset value. On the other hand, investment banks are often able to generate sources of supplementary revenue for themselves on the back of swap transactions, some of which they may share with the ETF through more generous swap terms. Therefore, the existence of the swap is capable of enhancing the underlying index return and offsetting the ETF’s management fees to some extent. Synthetic replication can sometimes also mean that an ETF does not pay dividends but simply rolls up its total capital and income return within its asset value so it is important that income-seeking invetors ascertain whether or not this is the case


Are ETFS a good way of investing in alternative asset classes

ETFs render many alternative asset classes investible to those investors who might otherwise find it difficult or impractical to participate.

Substantial sums of money are often required in order to participate directly in asset classes like property, infrastructure and private equity, it is difficult to achieve suitable diversification, management costs can be high, the administration can be complicated and, particularly important ,they are illiquid. Using ETFs to invest in alternative asset classes solves these problems. They are simple listed investments that track the indices of the listed companies operating in these fields.

On the other hand, it needs to be kept in mind that investing in asset classes like these through ETFs that track the relevant indices of listed companies, will result in more volatility in capital value than investing in physical property, physical infrastructure and private equity investments or funds of physical investments in these fields. This risks undermining the so-called  “low correlation” argument for alternative investment.

One of the main arguments that is advanced for alternative investments is their low correlation with more mainstream investments. In other words, many alternative investments might hold their value better during periods of falling equity markets, albeit perhaps lagging rising markets. Listed companies and their associated ETFs in fields like property, infrastructure and private equity cannot be depended upon to display this low correlation in the short-term. Although their medium and long-term performance will be driven byt he performance of their underlying asset class, the fact that they are listed and their prices can change by the minute means that they will inevitably be caught up in major stock market moves.

However, the correlation argument for alternative investment can be over-stated. Many alternative investments are only valued periodically. For example, physical property or a private equity investment may be carried in a portfolio at a fixed value between valuation dates which will lend an air of stability during periods of volatile stock markets. However, if the economic environment which is causing that stock market volatility also means that the property or private equity investment is re-valued up or down by 15% at a stroke when the next periodic valuation date comes around, that stability and low correlation will have been to some extent illusory.

Low correlation that is structural in character rather than temporary is difficult to find. Ultimately, the performance of all “real” asset classes will tend to be driven by a common set of factors of which economic growth is often the most important. Ultimately, the performance of all “monetary” asset classes will tend to be driven by a common set of factors of which the level of interest rates is often the most important.

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We belive that carefully considered asset allocation decisons is the cruicial part in the investment management process and argue that identifying the correct asset classes in which to invest is more important than selecting the underlying stocks.