Is the way European exchange-traded funds invest in swaps a better mousetrap for fixed-income than the current practice being used in the U.S.?

Although swap-based ETFs exist in the U.S.―this is the standard model for leveraged ETFs, for example―in Europe, the majority of ETF issuers use swap-based replication for all their funds.

As a result, European investors have access to ETFs that track everything from overnight interbank money market rates to credit derivatives indexes and inflation swap markets―three asset classes that are absent from U.S. providers’ product offerings.

The reasons for this historical difference in the two respective ETF markets’ evolution are quite complex and primarily reflect divergences in the two regions’ regulatory and tax regimes.

How Swap-Based ETFs Work

Swaps are generally one-off derivative contracts. Such deals are negotiated between two counterparties in which the two parties agree to exchange a pattern of returns―say, the return of the Barclays Capital U.S. Aggregate Bond Index―for the return of a particular rate of interest.

By using swaps, institutional investors can mirror the performance of virtually any security without anyone actually purchasing the underlying one. That makes swaps extremely flexible and powerful tools.

In a standard European swap-based ETF, when investors’ cash enters the fund as a result of a new creation of ETF shares, it is used to purchase a basket of securities (called the “collateral” or “substitute” basket). This basket may or may not have anything to do with the index being tracked.

The fund achieves its index exposure by entering into an index swap agreement with a counterparty, often the parent bank of the ETF issuer or, in the case of ETF issuer “platforms,” one of a group of financial institutions.

The index swap guarantees the performance of the underlying index to the ETF (net of the management fee), and herein lies one of the key attractions of swap-based ETFs―their reduced tracking error. However, nothing comes free, and the “price” that the ETF investor pays for receiving this superior tracking ability is some counterparty risk exposure to the bank writing the swap.

It’s important to understand that this counterparty risk is not of the same magnitude of the risks borne by exchange-traded notes in the U.S.

Under the UCITS rules (the regulations governing European collective investment schemes, with which most European ETFs are compliant), counterparty exposure is limited to 10% of the fund’s net asset value and, in practice, many ETF issuers manage this exposure to a lower maximum percentage figure. Nevertheless, fears over possible bank failures late last year were sufficient to drive many investors away from swap-based ETFs in favor of the more traditional “in-kind” ETF structure. So far in 2009, counterparty risk concerns have subsided.

Figure 1shows the 15 largest fixed-income ETFs in Europe, together with their annual fee and index-tracking methodology, as given in the August 6 Deutsche Bank “European Listed ETF - Liquidity Trends” report.

Figure 1

Source: Deutsche Bank Liquidity Trends Report. Data as of August 6, 2009.

The group is pretty evenly divided between the two types of replication methodology: seven track their indexes using the in-kind technique; eight use swaps. It can also be seen from the table that the type of replication technique used has no obvious effect on the funds’ headline fees.

The leading ETF managers in Europe are also neatly split by the types of funds they offer. iShares, Europe’s biggest issuer, so far uses only the in-kind model for its fixed-income trackers (though it does have a range of swap-based funds tracking European equity sectors). Lyxor and db x-trackers, the second- and third-largest ETF issuers in Europe, stick to swaps for all their ETFs.

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