ETF Innovation – Some Good and Bad Ideas Coming out of Europe

The Financial Times adventurous reporter David Stevenson rounds up the latest innovations in the exchange traded fund world in his article Momentum syndrome.

First the good idea. Tracking error, although typically small for most funds, is practically eliminated by a new approach taken in Europe by Lyxor and Deutsche Bank.

Both fund managers construct ETFs with a basket of stocks. However, 10% of the fund is set aside to purchase a derivative contract issued by a counterparty that guarantees to produce the index return. This swap helps to smooth returns and reduce the tracking error, although it introduces the risk of counterparty failure.

The bad idea is an innovation by the investment company ETF Securities. It uses a swap for 10 per cent but with two counterparties to minimize the risk. And the other 90 per cent is not invested in an actual basket of shares but in money market funds – the income from which is used to pay for the swap that in turn guarantees the index return.

The problem with this set up is that both money market funds and the swaps are dependent on the creditworthiness of the banks and counterparties. 2008 is proof that this approach presents risk that isn’t necessarily justified by the extra tweak in performance.

Stevenson does like the Russell 1000 (IWB) and Russell 2000 (IWM) index ETFs. He believes that the Russell 2000 fund, which tracks the premier US Small Cap index, will be one of the very best ways of buying into a US equity market recovery.

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