Paving the way for cost-effective new generation of swap ETFs

Thomas Uhlmann, INDEXCHANGE Investment AG
Originally published in the April 2006 issue

Exchange traded funds have one major advantage: They empower the investor to track the performance of specific market segments more efficiently and reduce costs. Institutional investors can use ETFs to create more efficient portfolios and utilize them for core-satellite strategies. A new category of ETFs recently introduced by INDEXCHANGE mirrors the underlying index even more accurately than usual and reduces trading costs by taking advantage of the UCITS III European Directive.

Conventional exchange traded funds directly mirror the underlying index by acquiring the securities that are contained in the index. The UCITS III European Directive, however, opens new windows of opportunity for ETFs. It extends the use of derivative financial instruments. As a company, INDEXCHANGE has been able to capitalise on this opportunity to create 18 swap exchange traded funds that create new advantages for investors. Instead of acquiring the securities contained in the index, INDEXCHANGE tracks the indices through the use of derivative financial instruments, in this case an equity sector swap. Last year, the funds proved to have very attractive returns relative to their volatility. The best performer was the Dow Jones STOXX 600 Basic Resources Swap with returns of approximately 50%, while having a volatility of less than 20%.

When an index is tracked through the acquisition of securities, some European countries levy significant taxes or transaction fees. For example, in Great Britain a stamp duty for buying stocks of 0.5% is charged. In Ireland and Switzerland 1% is charged for every transaction. These charges are not reflected in the index and for investors they reduce the fund performance. By using equity swaps we avoid these non-index costs and allow investors to ignore such charges in the future. Opposite to income from securities, compensation from swaps payments is not subject to income tax on a fund basis. Accordingly, at the end of the fiscal year, the fund price of the swap ETF is not reduced due to tax issues.

Reducing transaction costs

By avoiding foreign taxation this new category of exchange traded funds is able to mirror their respective benchmarks more accurately. The index replication can be increased to nearly 100% and cash drags can be reduced. It serves to significantly reduce the spread that is the difference between the purchase price and the sales price, representing an enormous saving for trading-oriented investors. The average spread for the new swap ETFs amounts to 0.2% round trip for example. Additionally, the high liquidity provided by market makers alleviates transactions of swap ETFs. Besides that, no counterparty commitment is required, as investors can buy and sell via the stock exchange. Buyers also benefit from the favourable cost structures calculated for institutional investors. The annual administration fees are only 0.3% compared to conventional sector funds charging often up to approximately 1.5% per year. Besides that, no issue premium is charged while trading via the stock exchange or OTC.

A German pioneer and European market leader, INDEXCHANGE currently provides 18 different exchange traded funds for European sector indices that are based on equity sector swaps, such as for banks, basic resources or insurance. It is an independently operating affiliate of HVB AG/UniCredit Group specialising in designing and managing exchange traded funds. It has pioneered the development of ETFs with numerous products currently listed in Europe. For example, it was the first to issue a fully replicating fixed income exchange traded fund family as well as Dividend ETFs and Eastern Europe ETFs.

The firm's 66 ETFs make INDEXCHANGE one of the most comprehensive and largest, ranked worldwide, among the top 10 providers of ETFs.

Founded in October 2000 INDEXCHANGE was the first German provider of ETFs and has grown to be today's market leader for European exchange traded funds. The product range includes the German, Swiss and British blue chip index as well as STOXX, EURO STOXX and Dow Jones indices. In 2005, the firm increased its assets under management by more than 60% to currently €10.4 billion.