The old investors’ advice to “Never invest in something you don’t understand” strikes a powerful chord in the wake of warnings about the risks of Exchange Traded Funds (ETFs).

Often tagged as exotic in comparison to their physical ETF brethren, synthetic (aka swap-based) ETFs use financial engineering to achieve the same ends, but in ways that pose specific risks that every passive investor should know about.

What is a synthetic ETF?

A synthetic ETF is designed to deliver the return of a selected index (e.g. the FTSE 100) just like any other tracker.

But it’s the way the synthetic ETF comes by that return that reveals its exotic nature.

The most obvious way to track an index is to own all (or most) of its component securities in the same proportion as that index. This way, the ETF should spout the index return minus costs and a few other inefficiencies. That’s how a physical ETF does it.

But a synthetic ETF doesn’t bother with any of that old pony.

Why go to the trouble of actually owning the shares of an index when you can deliver its return using a total return swap?

A total return swap is a financial derivative. In the case of a synthetic ETF, it’s a contract struck with a financial partner (known as a counterparty) to pay the ETF the precise return of its chosen index (both capital gains and dividends) in exchange for a stream of cash.

With a total return swap in place, the synthetic ETF can imitate an index without owning a single one of the benchmark’s securities.

Short-circuiting ownership means synthetics can overcome many of the tracking error issues that dog physically buying an index.

Synthetic ETFs are not tracking error-free, though. Performance is still leeched due to the fund’s TER, and other operational costs like the fee for the swap itself.

Problems? What problems?

Synthetic ETFs are often used to forage in markets that would otherwise defy tracking because of:

• Illiquidity
• Inaccessibility
• The huge numbers of securities to physically track

Many small cap indices, for example, would require a physical ETF to own a massive constellation of equities that would be costly and time-consuming to trade, due to market illiquidity and yawning bid-offer spreads.

The effort involved would make physical replication too expensive, so synthetic ETFs step in like robots cleaning up a nuclear reactor. The explosion in synthetic ETF numbers over the last few years shows how successful they’ve been in opening up markets where physicals fear to tread. Few niches are off limits when you can just buy the return with a derivative.

Ah, those problems… counterparty risk

A synthetic ETF’s reliance on derivatives may well send a little shudder down your spine. Derivatives haven’t had a good press ever since credit default swaps triggered the worst financial crisis since the Great Depression.

You’re absolutely right to be wary. All this financial engineering doesn’t come for free. The reduction in tracking error comes at the price of heightened counterparty risk.

Counterparty risk is the chance that the total return swap provider – even a seemingly indestructible entity like a giant investment bank – goes belly up. Lehman Brothers is the example of a counterparty crash par excellence.

If the worst happens, then the ETF’s source of return is cut-off and it’s time to fall back on the collateral.

Collateral damage

Investor cash sunk into a synthetic ETF doesn’t just go towards buying a total return swap. It’s also meant to buy enough collateral (almost) to fend off disaster.

So if the fund’s counterparty blows up, the collateral is sold off and investors (hopefully) get the value of their shares back.

Collateral can be held in cash, bonds and the equities of OECD countries. What’s more, European regulations limit counterparty exposure to no more than 10% of a fund’s Net Asset Value (NAV). In other words, the ETF must be backed by collateral worth at least 90% of its market value.

In practice, more collateral is often posted than required (known as over-collateralisation), and the ETF may be backed by up to 120% of its value in collateral.

The collateral quality counts as much as the quantity. There is no requirement for collateral to be held in the same securities that the ETF tracks. That means the ETF’s collateral basket can be stuffed full of all kinds of whiffy securities – Japanese small caps, unrated bonds – that could be hard to shift in an emergency.

The longer it takes to sell off the collateral, the more likely it is to plummet in value in comparison to the ETF. (And let’s face it, the chances are a counterparty will only fail during torrid market conditions.) If that happens then investors take a haircut.

i.e. They won’t receive the full market value of their ETF shares.

A number of ETF providers publish their collateral policy and the contents of each fund’s collateral basket on their website. I’d argue such knowledge is of limited use to retail investors, though.

Swap types to look out for

How ETF providers fund the total return swap has implications for the amount of collateral a synthetic ETF can call on in a crisis.

Two types of swap are commonly used:

1. Unfunded swap

• Investors’ cash is used to buy securities that make up the basket of collateral.
• The return on this basket is swapped with a counterparty for the return on the index.
• There is little, if any, over-collateralisation.
• The collateral is legally owned by the ETF provider.

2. Funded or pre-paid swap

• Investor cash is paid to the swap counterparty.
• The counterparty pays the ETF the index return.
• Collateral is pledged to the ETF’s account held with an independent custodian.
• The ETF is often over-collateralised up to 120% of NAV.
• The collateral is only available to the ETF if the counterparty goes bust.
• The ETF provider is not the beneficial owner of the collateral assets.

That last point is crucial. Because the collateral is pledged and not legally owned by the ETF, it can be frozen by a bankruptcy administrator stepping in to clean up the mess left by a failed counterparty.

In that scenario, the collateral isn’t released to the ETF provider as promised, but is caught up in the scramble to pick the best bits from the bank’s carcass. This happened during Lehman’s demise, and some investors (though not all) were left dangling for their cash.

Using synthetic ETFs

Synthetic ETFs are not constructs to be feared like killer ASIMO ‘bots from the future. But they do have features to be wary of (as do all investments) and they are certainly more complicated than physical ETFs.

So in general, I prefer to use physical ETFs, when I have the choice.

Bear in mind, too, that when you look at the securities listed in the index section of a synthetic ETF’s webpage, you aren’t seeing what the ETF owns. This list only reflects the composition of the index that the ETF artificially tracks via the total return swap. What the ETF physically owns, if anything, is found in the collateral basket section of the webpage.

There are other synthetic tracker vehicles out there: Certificates, ETNs and some ETCs. They work differently again from synthetic ETFs, but we’ll leave them for another day.

Take it steady,

The Accumulator

Thoughts from around the Web.

Run, don’t walk, to put some money into the new five-year index-linked certificates from National Savings & Investments.

NS&I is a wing of the UK government, and money you invest with it is 100% capital protected.

You may remember that NS&I’s index-linked certificates were withdrawn due to excess demand last year. Commercial banks have rushed to fill the gap with inflation-proofed bonds, but these are less attractive and based in some cases on derivatives. The Post Office also launched a bond, but it could not be held in an ISA, making the income taxable.

The new 5-year certificates from NS&I offer annual tax-free gains of RPI + 0.5%.

As the FT notes:

If RPI inflation remained at its March level of 5.3 per cent, the certificates would pay 5.8 per cent interest tax free. To achieve that return from a conventional, taxed savings account, a basic-rate taxpayer would need to earn a gross rate of 7.25 per cent, a higher-rate taxpayer would need to earn 9.67 per cent, and a 50 per cent taxpayer would need to earn 11.60 per cent.

It’s good news that NS& have continued to link to RPI, as I wrote when we first got wind these certificates would return.

The 0.5% rate above inflation is fair in these low interest rate times, though less than the old rate.

Of course, there’s every chance that inflation could fall and interest payable on ordinary savings accounts rise over the next five-years, which could make these certificates uncompetitive. But that is not the point.

Their value as part of your portfolio is diversification on unbeatable terms. No other inflation hedge can give you a guaranteed real return above inflation with zero risk to your capital. They’re a rare break for private investors, too. Banks and other institutions have to buy index-linked gilts, the price of which fluctuates, unlike the capital value of these certificates.

You can even withdraw your money early if the certificates get too uncompetitive, albeit with a reduction in the payment of interest due for the first year.

In short, even limited to £15,000 maximum investment per person, the limited issuance is likely to be snapped up very soon. Blogger Simple Living in Suffolk is beside himself with joy:

All in all, pretty awesome, a safe home for your cash. You aren’t going to get rich on it, but your cash is worth as much at the end of the five year term as it was at the beginning, there’ll just be more of it. I kind of like that in cash.

As I say, I see the certificates as a diversification play as much as about return. I am a chap who loves cash in a portfolio, anyway, but these certificates go an extra mile in usefulness.

Their appeal is an interesting sign of the times. It’s hard to remember the days when you could routinely get a real return (i.e. above inflation) from a savings account of 3% or so, yet that was the case for an account-hopping saver just a few years back.

Those days will return, and it may then be hard to remember why we got so excited about these new certificates.

[continue reading…]

I am now the proud owner of a new high yield share portfolio.

Since the method for picking the portfolio’s shares was not exciting enough to prompt Simon Cowell call me up with an offer to turn it into the new X Factor, we’ll not go through it again.

Instead, please refer back to see which high yield shares I bought and why.

This post will detail how much it cost to buy the 20 companies in my new HYP, and where I’m holding them.

In the future I’ll explain how I intend to manage the portfolio long-term, as well as what benchmarks we might use to judge its performance. Do subscribe to keep on-board with progress.

An ideal home for my High Yield Portfolio

As mentioned last time, all the online tools I tested to track a paper portfolio were flawed in some way, especially when it came to dividends.

So I decided to do it the proper way with real money. Carlsberg don’t do model share portfolios, but if they did they’d probably do the same thing.

Readers, much as I love you, I did not want to sink my entire wealth into a new portfolio, least of all one that I won’t be able to sell for years. (Houses don’t just buy themselves, you know).

I therefore limited my invested funds to £5,000.

Now, that’s not exactly a token amount of money, but it’s too modest to withstand much share purchasing at £10 or more a pop with 20 of the blighters to buy. But happily there is a cheap way to buy shares that’s worth exploring if you don’t have a lot to invest: Halifax’s Sharebuilder service.

The great attraction of Sharebuilder is it enables you to buy shares for a mere £1.50 an order – a fraction of the normal dealing fees at rival online brokers.

I have had a Halifax Sharebuilder account for many years, having originally opened it to buy a portfolio for income. (Long-time readers may remember my pain at calculating capital gains on the reinvested dividends. Not a mistake I will make again!)

Halifax enables you to run multiple accounts under the one roof, so it was a simple matter to allocate a new one for the Monevator HYP.

How to do the £1.50 share purchasing shimmy

The Sharebuilder service was conceived for people who want to transfer in perhaps £300 from their salary each month, and then build up a portfolio by regularly investing into a slate of shareholdings.

It’s a great idea in theory, and I’m all for encouraging wider share ownership. But in practice it can be costly if you invest too little per month, or if you spread yourself across too many holdings, even with just £1.50 trading fees.

For example, invest £300 across six different companies or ETFs every month, and you’ll pay £9 in dealing fees (£1.50 x 6), which is equivalent to 3% of your funds invested. That’s expensive.

But there’s a cunning plan! Rather than invest monthly, you can make a one-time investment of a larger lump sum, which is what I did. You can then turn this regularly reinvestment back off.

This is pretty much the equivalent of using the Sharebuilder like any other online broker, only it’s much cheaper. The snag is you can’t deal in real-time. Rather, you have to set up your trades the day before, and take whatever price you’re given in the market the next day.

In practice, when you’re buying a portfolio of blue chips at once, it doesn’t matter at all. Some will be higher priced on the day than you expected, and some lower, but it’s just random and nothing to worry about.

Of course, it doesn’t exactly make you feel like Gordon Gecko – more like your mum making out her Ocado grocery order. But we’re investing here, not playing Farmville for thrills, so that’s no bad thing.

Trading costs to buy my high yield shares

Faustian pacts with Mammon aside, here’s what I paid to buy my model HYP:

Dealing fees: There are 20 companies in my new high yield portfolio, and I wanted to invest equal amounts into every one. This meant putting £250 into each company, for a cost of £1.50 each time.

Stamp Duty: I also had to pay the UK’s ridiculous stamp duty tax for each transaction. This is a flat 0.5%, which came to £1.24 for each purchase.

The bid/offer spread: Market makers pay for their daughters’ school fees by charging you a bit more for shares they sell you than they will pay to buy them off you (think of a currency exchange at the airport). This bid/offer spread increases your costs, but for very big companies like those in the Monevator HYP, the spread is tiny. So tiny, in fact, that I can’t be bothered to work it out for each share – we’re talking a few pennies for each purchase.

In total, that’s £2.74 per share purchase for fees and stamp duty, plus a titchy bit more each time for the spread.

Multiply it up and you get to £54.80, or just over 1% of my £5,000, plus the price of a hamburger for that bid/offer business.

What I got for my money

Obviously I bought a different numbers of shares for each £247.26 lump sum I had left after fees to put into each company, depending on the share price.

Sharebuilder does the sums for you – you just say how much you want to invest.

For example, Vodafone had a share price of about 168p last Friday, so my £247.26 bought me nearly 148 shares in that company. In contrast, I’ve got barely 11 Royal Dutch Shell shares to my name.

I say ‘nearly’ and ‘barely’ because Halifax Sharebuilder allocates you fractional holdings of shares (behind the scenes, your shares are lumped together with other customers in a pool). As it happens, I have specifically got “11.244775” Shell shares.

In reality, this precise number doesn’t make any odds. I’m interested in tracking the value of my shares, not the fiddly number I happen to own – as well as the total dividends they pay out, of course.

But for the record, I’ll conclude this post with a snapshot of exactly what I got for my money, and what share price I paid for them:

Company	Quantity	Cost per share
Aberdeen Asset Management	106.9	233.8p
Admiral	14.2	1,759.7p
AstraZeneca	8.0	3,121.1p
Aviva	56.4	443.4p
BAE Systems	76.1	328.6p
Balfour Beatty	75.6	330.6p
BHP Billiton	10.4	2,397.4p
British Land	41.8	597.5p
Centrica	79.3	315.1p
Diageo	20.1	1,245.5p
GlaxoSmithKline	19.0	1,318.3p
Halma	67.3	371.4p
HSBC	30.0	657.3p
Pearson	22.0	1,137.2p
Royal Dutch Shell	11.2	2,223.3p
Scottish & Southern Energy	18.9	1,351.0p
Tate	40.8	612.1p
Tesco	60.6	412.0p
Unilever	12.6	1,986.6p
Vodafone	147.9	169.0p

Note: Shareholdings and prices rounded to one decimal place. Costs include all fees.

Incidentally, having spent 30 minutes copying a load of fiddly numbers by sight from my web browser into this post – and rounding them as I go – I see one advantage of using an online tool… it would have done this for me!

Luckily I don’t plan on doing a review of the value more than every six months or so. This is a steady portfolio for income, remember, not a DIY hedge fund. 😉