- ETF explained
- Ossiam ETFs risk management guidelines
ETFs are open-ended investment funds listed on Stock Exchanges and traded intra-day, like equities. They are attractive investment tools that aim for consistency in delivering returns of a chosen market or strategy and are cost effective. ETFs are the most popular type of exchange traded products due largely to the transparency of their management process and the ease of access to creation and redemption of ETFs shares and their UCITS VI status.
The investment objective of most ETFs is to offer returns that replicate as closely as possible the performance of a selected index. For example, the objective of an ETF on the STOXX® Europe 600 Equal Weight Index will be to deliver, as accurately as possible, the performance of the STOXX® Europe 600 Equal Weight Index (increase or decrease). However, an ETF may have a performance that differs from the one of the index it is replicating (this performance can be higher or lower than the performance of the index). This is due to various reasons such as the capacity of the ETF manager to replicate the portfolio of stocks composing the index, taxation, management fees and expenses sustained by the ETF, etc…
ETFs managers can use different methods to replicate the performance of an index:
- Physical full replication;
- Physical sample replication;
- Synthetic replication.
Each management method has a different profile in terms of cost and capacity to replicate the index, and generates different risks, including counterparty risks
Physical full replication is not always possible or advisable. Indeed, if an index is composed of a large number of stocks the physical full replication may not be cost effective. Moreover, if some stocks of an index are not easily tradable because of domestic constraints, are not liquid or are subject to an adverse taxation the manager of an ETF may find that physical sample replication method will limit the tracking deviation of the ETF. Physical sample replication consists in managing a portfolio using a limited number of stocks in order to replicate the index while not being strictly in line with the index composition. For example, an ETF, in order to replicate the 1800 components of the MSCI World® Index could hold only a selection of 700 or 800 stocks which is optimized to limit the tracking error and costs associated.
In both physical replication methods described above, the ETF holds all, or part, of the stocks composing the index replicated. In synthetic replication (or swap based replication) methods, the ETF generally tracks the performance of an index by holding a basket of stocks called “substitute basket” and an index swap:
- The substitute basket is a selection of stocks that are included in the index composition or that can be different from the latter one. This selection of stocks has to comply with UCITS IV requirements as per the provisions of the 2009/65/EC directive.
- The index swap is a contract between the ETF and a counterparty according to which the ETF pays to the counterparty the performance of the substitute basket and receives from the counterparty the performance of the index.
This synthetic replication method, known as unfunded swap method, allows minimization of the tracking error with the index by receiving the exact performance of the index from an external counterparty. The net asset value of the fund will therefore increase (or decrease) according to the evolution of the index.
By entering an index swap agreement the ETF bears a counterparty risk. Indeed, if the counterparty of the swap is subject to a default, the ETF may not be able to recover all, or part, of the amount due from the counterparty and therefore incur a loss.
The fund may also enter into multiple swap agreements with multiple swap counterparties with the same characteristics as previously described with the aim of ensuring minimal deviation between the fund‘s return and the performance of the index.
Synthetic replication allows indices based on large universes or less liquid indices to be replicated accurately and efficiently without investors having to forego the desired high level of transparency.
The European UCITS (“Undertakings for Collective Investments in Transferable Securities”) Directive is a set of pan-European mutual funds regulations that set the standards for any collective investment scheme that is marketable in the European Union, including ETF. UCITS IV refers to the latest version of the UCITS requirements which came into effect in July 2011 . A UCITS fund may invest no more than 10% of its net assets in transferable securities or money market instruments issued by the same body, provided that the total value of transferable securities or money market instruments held in issuing bodies in each of which it can invest more than 5% is less than 40% . An index tracking fund such as ETF may invest up to 35% of its NAV in a single security, as long as no other security invested in the fund exceeds 20% of its NAV . In addition, the counterparty risk of a fund for any Over-The-Counter (OTC) transaction with a single counterparty must be limited to 10% of its NAV . All Ossiam ETF are compliant with these UCITS IV requirements .
- The method of replication is very straightforward : the ETF in principal holds the stocks that compose the tracked index;
- The ETF holders has a clear idea of what are the stocks the ETF is invested in.
Market Risk: the objective of the ETF being the replication of an index, the ETF holder will be subject to gain and loss similar to the performance of the index. This positive and negative performance will be a function of the evolution of the index;
- Liquidity Risk: in normal market conditions the liquidity of an ETF depends mainly on the liquidity of the underlying stocks that compose the index. The ETF holder may be unable to buy or sell ETF in the Stock Exchange due to technical reasons or to the absence of prices in the order book;
- Counterparty Risk: ETF that use physical sample and full replication methods generally implement stock lending activities in order to improve their performance. Stock lending activities enhance the returns of the ETF but generate a counterparty risk. Indeed, if the counterparty to which the stocks are lent is subject to default, the ETF may not be able to recover all or part of the stocks lent and incur a loss;
- Replication Risk: the tracking error of an ETF using physical sample or full replication methods can be important especially if the index tracked is composed of an important number of stocks and/or if the index has a large proportion of illiquid stocks or stocks that are difficult to trade for specific domestic rules or adverse tax regimes.
- The synthetic replication tends to reduce the tracking error significantly.
- For indices that have a large number of stocks or a proportion of stocks that are illiquid, difficult to trade for specific domestic rules or adverse tax regime, the synthetic replication is a method that may result in a better performance.
Market Risk: the objective of the ETF being the replication of an index, the ETF holders will be subject to gain and loss similar to the performance of the index. This positive and negative performance will be a function of the evolution of the index;
- Liquidity Risk: in normal market conditions the liquidity of an ETF depends mainly on the liquidity of the underlying stocks that compose the index. The ETF holders may be unable to buy or sell ETF in the Stock Exchange due to technical reasons;
- Counterparty Risk: the synthetic replication method allows minimization of the tracking error with the index by receiving the exact performance of the index from an external counterparty. By entering an index swap agreement the ETF bears a counterparty risk. Indeed, if the counterparty of the swap is subject to a default, the ETF may not be able to recover all or part of the amount due from the counterparty and thus incur a loss;
- Mismatch Risk: in synthetic replication methods the ETF tracks the performance of an index by holding a basket of stocks called “substitute basket” and an index swap. The stocks included in the substitute basket can be different from the ones that compose the index. In case of default of the index swap counterparty the ETF holder would be temporarily exposed to the substitute basket which composition would differ from the one of the Index.
Ossiam launched its first range of ETFs in May and June 2011. Those ETFs use the unfunded swap model. Each ETF buys a basket of securities and simultaneously enters into a swap agreement with one or several counterparties which commit to pay the index performance (adjusted for the swap price) in exchange for the performance of the fund holdings. Ossiam also launched ETFs using a full replication method – the first ETF using full replication with no securities lending was listed in January 2012 on the London Stock Exchange: Ossiam FTSE 100 Minimum Variance UCITS ETF 1C (GBP).
Ossiam selects the replication methods of its ETFs with the following objectives: minimizig the tracking error of the ETF, complying with the general risk constraints of ETF holders, offering the most cost effective solution.
In order to minimize the tracking error with an index, a synthetic replication method can be implemented by Ossiam to track the performance of this index.
When using synthetic replication (or swap based replication) Ossiam ETF tracks the performance of the index by holding a basket of stocks called “substitute basket” and an index swap. The “substitute basket” will represent at least 93% of the Ossiam ETF holdings (or NAV) while the total exposure to the index swap with one, or more counterparties, will be limited to 7% of the Ossiam ETF holdings (or NAV).
For the sake of transparency and in order to respect investors’ best interest:
- Each Ossiam ETF enters into swap agreements with one or several counterparties. Ossiam follows the best selection principles defined by the European Markets in Financial Instruments Directive (MiFID). These counterparties are selected through a bidding process that takes into consideration the risk profile and rating of the counterparty, the price of the Index Swap, the quality and management of securities delivered by the counterparty, the bid-ask spread and cut-off times for increases and decreases of the swap nominal value.
- There is no minimum number of swap providers for each ETF. As a result, at any given time, a fund may have exposure to a single counterparty while another may have exposure to several.
- Ossiam monitors its counterparties quality. Thus, new/existing providers may be added or removed subject to the suitability of swap arrangements agreed with the provider. According to UCITS rules, the counterparty risk of a fund on an Over-The-Counter (OTC) derivative with a single counterparty must be limited to 10% of its NAV. However, Ossiam has implemented tighter restrictions: the total counterparty exposure cannot be superior to 7% of the ETF holdings.
- Counterparty exposures are monitored on a daily basis by Ossiam (by the Chief Compliance Officer, the Chief Investment Officer and the Chief Risk Officer) and the custodian, State Street Bank Luxembourg S.A.
- The quality of the substitute basket is a crucial parameter for Ossiam in the selection of the counterparty. As a general rule, all Ossiam’s ETFs with European stocks will hold at least 75% of European Economic Area equity securities that have a first rate standing. For all other ETFs, the fund will include at least 60% of OECD equity securities. Ossiam tries to hold securities that are part of the fund benchmark index. The funds’ holdings are monitored by Ossiam and held in a segregated account by the custodian, State Street Bank. Luxembourg S.A.
- Every day Ossiam publishes the full composition of its ETF assets on this website including counterparty names and total counterparty exposure levels.
- Ossiam does not engage in securities lending.
Alpha: A measure of performance on a risk-adjusted basis. Percentage by which the portfolio or smart beta index outperforms (adjusted for risk) the comparable market capitalization weighted index from which the stocks are picked.
Asset allocation: The breakdown of the investments of a portfolio among various asset classes (such as equities, bonds, money market instruments, etc.), built in order to optimize the risk/return ratio of the investor's portfolio, in light of his or her financial situation, investment objective, investment horizon and appetite for risk.
Benchmark: A reference used as a comparison to determine the returns and risk of a portfolio. The benchmark may be an index or a combination of several reference indices.
Beta: The Beta of an investment indicates whether it tends to evolve in the same direction as the market, and in what proportion. Thus, the beta coefficient measures the sensitivity of a portfolio or share to market movements or an index.
Bid/Ask: Bid - Purchase price given or displayed by a market maker on an exchange (or over-the-counter), which corresponds to the sale price for the end investor. Ask - Sale price given or displayed by a market maker on an exchange (or over-the-counter), which corresponds to the purchase price for the end investor. There is usually a difference between the bid price and the ask price for an asset on the order book. This difference is called the spread and varies from one ETF to another. It tends to increase when the volumes being traded are low. One of its drivers is the liquidity of the underlying.
CAPE: CAPE - Cyclically Adjusted Price Earnings. The CAPE ratio is the PER adjusted for cyclical factors. It relates the share price to corporate earnings over the past ten years. Compared to the standard PER, it eliminates short-term fluctuations in earnings, which can distort the picture. Relative CAPE - CAPE standardized to make individual sectors comparable. It is defined as the CAPE® ratio divided by its median in past years. A Relative CAPE® ratio of 1 shows that the current valuation is in line with the long-term average, while figures lower (resp. higher) than 1 point to the sector’s possible undervaluation (resp. overvaluation).
Correlation: Measure for the dependence of the performance of two securities, indices or asset classes on each other. The correlation can be between -1 and 1, whereby 1 means they perform exactly in parallel, -1 that they perform in exactly opposite directions. The closer to 0 the correlation, the more independent the two performances are.
CPPI: Constance Proportion Portfolio Insurance, a method of portfolio insurance in which the investor sets a floor on the currency value of his or her portfolio, then structures asset allocation around that decision. The two asset classes used in CPPI are a risky asset (usually equities or mutual funds), and a riskless asset of either cash, equivalents or Treasury bonds. The percentage allocated to each depends on the "cushion" value, defined as (current portfolio value – floor value), and a multiplier coefficient, where a higher number denotes a more aggressive strategy.
Diversification: Portfolio constrction reducing the exposure to the risk of capital loss by investing in uncorrelated assets at the same time. Diversification therefore consists in distributing an investment among different business sectors, asset classes, geographic regions, etc.
Diversification indices: Indices that focus on broader diversification by an alternative weighting of the securities in the index, for example by weighting all the securities equally.
Gain: Gain generated on the difference between the purchase price of an asset and its subsequent sale price (exclusive of charges and fees paid in connection with the purchase and sale of an asset).
ESG: ESG integration consists of integrating Environmental, Social and Governance (ESG) criteria into the management of investments.
ETF: Exchange Traded Fund that tracks an index. ETFs passively mirror an index, without any active management being involved. Units of ETFs are traded on the exchanges like equities.
Fundamental indices: Indices weighted by fundamental criteria such as dividend yield, price/earnings ratio or other value criteria.
Hedging: Strategy whose objective is to totally or partially offset the risk associated with an investment by making a second transaction that combines long and/or short positions in transferable securities, precisely in order to reduce the risk of the first position. For example, the risk of a long-term position in equities may be offset by the purchase of put options. Thus, investors may limit the impact of a decline in the prices in their portfolio.
Index: Instrument to measure capital markets’ performance. Indices exist for various asset classes (shares, bonds, commodities), countries and regions, and sectors. An index brings together the securities representative of the market to be tracked in line with fixed rules.
Index based on market capitalization: Traditional stock indices where weightings of the individual shares are proportional to their market capitalizations, meaning the share prices multiplied by the number of shares issued, adjusted for free-float. Most of the main stock market indices are compiled using this method.
ISIN (International Securities Identification Number): This unique international identifier is used to distinguish financial instruments, such as shares, bonds, funds, etc. The ISIN code is a unique international alphanumeric code of 12 characters (of which the first two letters identify the country of issue of the security, e.g. FR for France). Shares always keep the same ISIN codes, even if they are traded in different currencies or listed on different markets. Each ETF has its own ISIN code.
KIID (Key Investor Information Document): The KIID is a regulatory document, standardized on a European level, providing investors with key information on a fund in terms of its objectives, risks, performance and costs, so that, when making investment decisions, investors are in a position to understand the nature of the fund and the risks associated with it. This document must be provided to the investor prior to any subscription. Introduced by the European Directive 2009/65/EC of 13 July 2009, this document replaces the simplified prospectus.
Loss: Loss resulting from the difference between the original acquisition price of an asset and its subsequent sale price.
Market Maker or Liquidity provider: A financial institution whose role is to facilitate the trading of financial instruments, including ETFs. During trading hours, the market maker provides quotations for the product on the relevant stock exchange and places bid/offer orders continuously, so that investors can trade their financial instruments (such as ETFs) at any time.
Maximum Drawdown: The maximum drawdown, or "maximum successive loss", is an indicator of the risk of a portfolio chosen on the basis of a certain strategy. The maximum drawdown measures the largest decrease in the value of a portfolio. Precisely, it corresponds to the historical maximum loss incurred by an investor who bought the highest and resold at the lowest, for a fixed period.
NAV / NAV per Share: The Net Asset Value corresponds to the total value of the fund assets. The NAV per Share is the NAV divided by the number of shares in the fund.
OTC – Over-the-counter: A trade which takes place off the exchange directly between two identified parties (counterparties). On an OTC market, market makers seek to provide liquidity for the various assets for which they propose bid and offer prices.
PER (Price/Earnings Ratio) : The PER divides the share price of a company to its earnings per share. The PER serves as a key indicator for how shares are valued. The lower the PER, the more favorably the share is priced on the stock market.
Physical replication: Physical replication consists in holding the securities comprising the replicated index. This replication may be “perfect”, in this case the fund holds all the securities of the index and in the same proportions as in the index. It may also be done through "sampling", in this case the fund holds only part of the securities of the index selected in order to offer performance as close as possible to the performance of the index.
Price return: A “Price Return” index tracks the evolution of prices of its component equities or bonds, without including dividends that may be paid by such equities or coupons in the case of bonds.
Risk-based indices: Indices that use risk measures, such as volatility, to allocate the stocks. In general, risk-based indices seek to systematically reduce volatility compared to a classic index. Examples of risk based indices are minimum variance or risk parity indices.
Share class: Some funds and ETFs have multiple share classes. These may differ by the currency in which they are denominated, the distribution or capitalization of dividends, their costs or minimum tradeable size. Each share class has a unique specific ISIN code.
Sharpe ratio: Indicator for the portfolio’s profitability in relation to the risk taken. Developed by US economist William F. Sharpe, the figure presents the return in excess of a risk-free interest rate divided by the portfolio’s volatility.
Smart beta: Rule-based investment strategies that use an alternative weighting for the securities covered by an index to deliver better risk-adjusted results than the underlying traditional index.
Spread: The difference between the Bid and Ask price of an asset. The spread generally varies depending on supply and demand for a particular asset and on the volume traded (liquidity).
Stock market price: The price of an asset as determined by levels of supply and demand on the stock market. Please note that the stock market price of an ETF may differ from its net asset value (NAV). It will, however, fall within a range based on the indicative Net Asset Value.
Swap (forward swap agreement): An OTC swap agreement between two parties in relation to an exchange to be executed at a future date and at a pre-determined or determinable price. The expiry dates, delivery dates, quantities and contractual terms and conditions for each agreement are standardized. ETFs using synthetic replication methods use swaps: they swap with a counterparty the performance of the assets they hold for the performance of the benchmark index. The mark-to-market value of a swap is equivalent to the amount owed to the ETF by the counterparty (if the value is positive) or owed to the counterparty by the ETF (if the value is negative). In the absence of collateral, the mark-to-market value of the swap represents the counterparty risk. For ETFs, the level of exposure to the swap is subject to regulations, and limited to 10% of the assets per counterparty in the case of UCITS ETFs.
Swap counterparty: Entity with which the Total Return Swap is entered into.
Synthetic replication: For ETFs managed in synthetic replication, the replication of the index is generated by a Total Return Swap, i.e., a swap under which an investment bank (the counterparty) exchanges the performance of the index for another performance. In synthetic replication, there are two types of structures: - Unfunded structures, in which the fund uses its liquidity (generated for subscriptions in the fund) to purchase a basket of securities that it owns and whose performance is exchanged for the performance of the index in accordance with the provisions of the Total Return Swap; - Funded structures in which the fund transfers its cash to the counterparty, in exchange for the final value of the index at swap maturity, in accordance with the provisions of the Total Return Swap.
TER: The TER (Total Expense Ratio) is the sum of annual total management and operating fees billed to a fund relative to its net assets. For Amundi ETF funds (the “Funds”), the TER corresponds to the ongoing fees mentioned in the KIID. The ongoing fees represent the expenses deducted from the fund during the course of a year.
Total Return: In the case of “Total Return” indices, dividends paid by the equities (or coupons in the case of bonds) comprising the index are reinvested into the index, unlike a “Price Return” index. In general, an expression referring to the total profitability of an investment that may be expected, i.e., the sum of the capital gain related to selling the securities, and the dividends (or coupons) collected.
Tracking error: A measure of how closely an ETF follows the index to which it is benchmarked. The tracking error shows how the ETF mirrors the index. The lower the figure, the more exact the tracking.
UCITS (Undertakings for Collective Investment in Transferable Securities): European directive aimed at further harmonizing the European financial markets. It proposes a harmonized regulatory framework for European funds and particularly with respect to:
- rules relating to the organization of management companies managing funds,
- eligibility and composition of assets, risk diversification
- authorization for marketing within EU territory, etc.
Various directives have been successively implemented in the European Union.
Value trap: A well known challenge when investing in a value strategy. It refers to the risk taken by investors who opt for ostensibly favorably priced equities or sectors that then take a very long time to bounce back, if they do so at all.
Volatility: A measure of the magnitude of the fluctuations for a security or index across a certain period of time, measured as the standard deviation of returns. It serves as a measure of an investment’s risk.