Chapter 17 - Derivative-Based Exchange-Traded Funds

Question 1

Explain how futures contracts may be used in the creation of an ETF.

Answer 1

• In the case of synthetic replication, ETFs have no physical holdings of the underlying assets. Instead, if the
  underlying assets are costly to own and have established and active futures contracts available on them, ETFs
  hold futures contracts to track and deliver the underlying asset returns.
• Futures contracts are the most popular type of derivative used in commodity ETFs.

Question 2

Explain how swap agreements may be used in the creation of an ETF.

Answer 2

• Leveraged and inverse ETFs typically use swap agreements to deliver the leveraged and/or inverse return of an
  underlying asset.
• In an unfunded swap structure, an ETF obtains the leveraged or inverse return from a swap provider in
  exchange for the return of a portfolio chosen by the swap provider. The portfolio is detained by the ETF and
  serves as collateral in case of default by the swap provider.
• In a funded swap structure, an ETF also obtains the leveraged or inverse return from a swap provider but
  against a cash deposit that the swap provider utilizes to hedge its risk exposure. The swap provider has to post
  collateral that is pledged to the ETF.

Question 3

Explain the unique risks to investors of derivative-based ETFs.

Answer 3

• For derivatives-based ETFs that use futures contracts, the slope of a futures curve has a direct impact on the
  return achieved by the ETF. For futures markets that are in contango, rolling forward contracts represents a
  financial drag on performance as ETFs must absorb losses on the rolls.
• With swap-based ETFs, the swap counterparties have to post collateral. Should a swap counterparty default,
  the level of protection for ETF investors will depend on 1) how rapidly the ETF can access the collateral basket,
  2) the quality of the securities in the collateral basket, and 3) how easily these securities can be liquidated at a
  fair price in a potentially distressed market.
• Since most leveraged and inverse ETFs reset daily, their performance over longer holding periods can differ
  significantly from the performance of their underlying index or benchmark over comparable periods.
• The necessity for a leveraged long ETF to constantly increase its long derivative market exposure after an
  up day and decrease its long derivative market exposure after a down day makes highly volatile markets
  with numerous trend reversals treacherous and costly. The same goes for a leveraged inverse ETF that has
  to increase its short derivative market exposure after a down day and decrease its short derivative market
  exposure after an up day. In highly volatile markets, ETFs have to frequently offset at a loss the positions
  just taken.

Question 4

What is a collateral basket?

Answer 4

A basket of collateral assets pledged
to or received by a swap-based
ETF, reducing this way the ETF’s
counterparty risk exposure to the swap
provider.

Question 5

What is a funded swap?

Answer 5

Under a funded swap ETF structure, a
swap-based ETF transfers cash equal
to a desired notional exposure to the
swap provider, which then provides
the market return of the index the
ETF is trying to replicate. To offset the
counterparty risk exposure, the swap
provider has to post collateral that is
pledged to the ETF.

Question 6

What is an unfunded swap?

Answer 6

Under an unfunded swap ETF
structure, a swap-based ETF transfers
cash equal to a desired notional
exposure to the swap provider, which
then transfers a basket of collateral
assets to the ETF. The total return
on this collateral basket is then
transferred to the swap provider in
exchange for the market return of the
index the ETF is trying to replicate.

Question 7

Explain how the shape of a futures curve can affect positively or negatively the total return of a futures-based
ETF.

Answer 7

In a futures market in backwardation, an ETF rolling its contracts would buy the next month’s contracts for a
lower price than it sells the current month’s contracts. This creates what is known as positive roll yield and will
add to the total return of the ETF. In a futures market in contango, an ETF rolling its contracts would buy the
next month’s contracts at a higher price than it sells the current month’s contracts, creating net losses on each
roll and representing a severe financial performance drag for the ETF.

Question 8

Explain the necessity for daily-reset leveraged and inverse ETFs to rebalance their derivative position in the
same direction as the daily price changes of their underlying assets.

Answer 8

Market price changes affect proportionally more the NAVPS of a leveraged fund than the market value
exposure of the derivative position used to deliver the leverage.
To maintain a stated leverage ratio after an up day, a leveraged ETF must adjust upward its long derivative
market exposure and a leveraged inverse ETF must reduce (buy back) part of its short derivative market
exposure.
To maintain a stated leverage ratio after a down day, a leveraged ETF must reduce (sell back) part of its
long derivative market exposure and a leveraged inverse ETF must adjust upward its short derivative market
exposure.

Question 9

Should the swap counterparty in a swap-based ETF default, which of the following elements is not a key factor
in determining the level of protection of ETF investors?
a. The quality of the securities in the collateral basket.
b. How rapidly the ETF can access the collateral basket.
c. The fact that an ETF is leveraged but not inverse.
d. How easily these securities can be liquidated at a fair price.

Answer 9

c.