What are the pros and cons of using swap-based ETFs? - MoneySense (2024)

FAQs

What are the risks of swap based ETF? ›

Potential risk of losing money: Counterparty

The quality of the counterparty and the liquidity and value of the collateral are key concerns for these ETFs. Synthetic structures involve fees that are classified as trading costs but should be considered an overall cost of the structure.

Synthetic ETFs (also called swap ETFs) are a cost-effective alternative to invest in niche markets or asset classes such as commodities and money market, which would otherwise not be accessible to most investors. In addition, swap ETFs are able to track some markets more efficient and accurate than physical ETFs.

In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends. Still, unique risks can arise from holding ETFs as well as tax considerations, depending on the type of ETF.

Swap-based ETFs are a type of exchange-traded fund (ETF) that doesn't directly hold stocks or bonds. The fund uses a “total-return swap” that delivers the same performance as an index, but without actually investing in any of the companies listed on the index.

1. Market risk. The single biggest risk in ETFs is market risk.

Replication method matters: Physical ETFs hold the underlying assets, while synthetics use swaps, impacting tracking error and risk. Counterparty risk is key: Both methods involve counterparty risk, but synthetic ETFs explicitly rely on a swap provider for returns, raising concerns in some investors.

1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs. 2) Swap can be used to hedge risk, and long time period hedge is possible. 3) It provides flexible and maintains informational advantages.

Positive aspects of ETFs

The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

Buying high and selling low

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business.

Why are ETFs riskier than mutual funds? ›

The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges.

ETFs can form a diverse foundation

The big advantage with ETFs is they offer an unmatched choice of assets, markets, and risk levels. That means there is probably an ETF to match your long-term needs at whatever life stage you are at. ETFs can help you build a strong foundation for your long-term investment portfolio.

What Is an Exchange Fund? An exchange fund, also known as a swap fund, is an arrangement between concentrated shareholders of different companies that pools shares and allows an investor to exchange their large holding of a single stock for units in the entire pool's portfolio.

Yes. Most funds that offer ETF Shares will allow you to convert from conventional shares of the same fund to ETF Shares. (Four of our bond ETFs—Total Bond Market, Short-Term Bond, Intermediate-Term Bond, and Long-Term Bond—don't allow for conversions.)

What are the risks. Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk. Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk.

Basis risk refers to the risk that the correlation between the fixed interest rate and the floating interest rate deviates from the expected or desired level.

Basis risk on a floating-to-fixed rate swap is the potential exposure of the issuer to the difference between the floating rate on the variable rate demand obligation bonds and the floating rate received from the swap counterparty.

Cross-currency basis swaps are a useful instrument for investors to manage their portfolio's currency risk. Super funds can also take advantage of imbalances between demand and supply in the cross-currency basis swap market to enhance yield and earn additional return.