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New ETFs improve index tracking and reduce trading costs

Exchange-traded funds allow investors to track the performance of specific market segments more efficiently and reduce costs, helping institutions to create more efficient portfolios for use in core-satellite strategies. A new category of innovative ETFs recently introduced by Indexchange takes advantage of the European Union's Ucits III directive to mirror the underlying index even more accurately while reducing trading costs.

Conventional ETFs directly mirror the underlying index by acquiring the securities that comprise the index. However, Ucits III opens new windows of opportunity for ETFs by extending the use of derivative financial instruments. Indexchange has taken advantage of this opportunity to create 18 innovative swap ETFs covering sectors such as banks, basic resources and insurance. Instead of acquiring the securities contained in the index, Indexchange tracks the indices through use of an equity sector swap. Last year, these innovative funds enjoyed very attractive returns relative to their volatility. The best performer was the Dow Jones STOXX 600 Basic Resources Swap with a return of around 50 per cent and volatility of less than 20 per cent.

The acquisition of securities to track an index can entail significant taxes or transaction fees in some European countries. For example, stamp duty of 0.5 per cent is charged on the purchase of stocks in the UK, while one per cent is levied for every transaction in Ireland and Switzerland. These charges are not reflected in the index and for investors they reduce the fund performance. Equity swaps avoid these nonindex costs and will not affect the performance enjoyed by investors in the future. By contrast with income from securities, income from swaps payments is not subject to income tax on a fund basis, which means the fund price of the swap ETF is not reduced by tax at the end of the fiscal year.

By avoiding foreign taxation, this new category of ETFs can mirror the funds' respective benchmarks more accurately, increasing index replication to nearly 100 per cent and reducing cash drag. This cuts the spread between purchase and sales prices and represents an enormous saving for trading-oriented investors. The average spread for the swap ETFs amounts to 0.2 per cent per round trip, for example. The high liquidity provided by marketmakers facilitates transactions of swap ETFs, while no counterparty commitment is required, as investors can buy and sell via a stock exchange. Institutional investors also benefit from favourable cost structures, with annual administration fees of only 0.3 per cent, compared with up to 1.5 per cent per year for conventional sector funds. In addition, no issue premium is charged when trading via a stock exchange or OTC.

Indexchange became the first German ETF provider when it was founded in October 2000 as an independent subsidiary of HVB, today part of the UniCredit Group. It now offers 76 ETFs encompassing the German, Swiss and UK blue chip indices as well as  the Dow Jones and STOXX index family, and has pioneered the sector's development through innovations such as the first fully replicating fixed income fund family, as well as dividend and Eastern Europe ETFs. Following growth of more than 60 per cent last year, it is the European market leader and one of the top 10 providers worldwide with EUR13 bn in assets.

By Thomas Uhlmann - chief marketing officer and a member of the management board of Indexchange Investment AG

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