And while UCITS rules impose quite strict diversification requirements on a fund's assets, or on an approved index for a UCITS-compliant tracker product, these diversification rules (often referred to as the "5/10/40" rules) do not extend to the collateral itself held by a swap-based ETF. However, some issuers do choose to back their swap-based ETFs with collateral consistent with the rules.

Critics of swap-based ETFs have pointed out that the composition of the collateral basket may bear little or no resemblance to the index being tracked, being in unrelated securities or even in an entirely unrelated asset class, and that the basket's composition is typically only revealed in the ETFs' annual and semi-annual report and accounts, leaving investors in the dark about what is in there the rest of the time. One leading swap-based ETF provider countered that there may be no disclosure at all about the collateral held and counterparty exposures incurred when ETFs' securities are lent out, as typically happens for funds that use an in specie replication methodology.

While some swap-based ETF providers have stated their willingness to reveal the collateral basket composition more frequently, on request, one pointed out to me the operational complexities that this would present, which might necessitate an increase in costs. This issuer also pointed out the ample scope for confusion between the "perfect basket" or "implied fund constituents" for a swap-based ETF—the securities constituting the index being tracked, whose composition is typically updated daily on ETF issuers' websites—and the securities held in the collateral basket.

Collateral for ETNs/ETCs/ETPs

Exchange-traded notes (ETNs) and other exchange-traded products, such as exchange-traded commodities (ETCs), operate outside the UCITS framework, since they typically offer exposure either to single assets (for example, a particular commodity) or to indices that do not meet UCITS diversification requirements.  A year ago no ETNs, and only a few ETCs (those tracking physical metals), had any effective collateral backing, so an investor typically carried full counterparty exposure either to the issuer, or to an intermediary company guaranteeing the return.  However, following the September failure of Lehman Brothers and the subsequent near-collapse of AIG, some issuers started to collateralise their trackers. 

ETF Securities' Commodity Securities range was relaunched on 20 October last year, with the creation of a Securities Intermediary (Bank of New York Mellon), which holds collateral pledged to the issuer by AIG Financial Products. The Commodity Securities ETCs represent more than half the firm's exchange-traded commodities ("ETCs") by number, though about one fifth by value (most assets invested in ETCs are in those backed by physical metal, under the ETFS Metal Securities and Gold Bullion Securities ranges, while around 6% of ETCs are uncollateralised, with performance guaranteed by Shell Trading Switzerland). More recently Lyxor has launched a collateralised ETN tracking gold, and plans to issue further notes under the same programme.

For ETF Securities, the collateralisation of the majority of its ETCs appears to have met with investor approval. Assets under management in the AIG-backed Commodity Securities (excluding forward, short and leveraged versions) fell from $3.3 billion in July 2008 to around $1 billion in October, partly reflecting the fall in commodity prices, but also withdrawals due to counterparty concerns. Assets have since rebounded to $2.1 billion, and have doubled since December.

Lyxor's Dan Draper said that his firm is seeking to throw light on the true cost of providing collateral by including a variable collateral charge in the Lyxor gold ETN's total expense ratio. This charge currently runs at an annual 74 basis points on top of the flat annual 0.30% fee, although Draper said that he expects the variable component to drop if and when credit markets stabilise. The charge relates specifically to the cost of funding the collateral held in the issuer's asset compartment backing the ETN: an S&P AAAf-rated eurozone government bond fund or government bonds.

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