Frontier market ETF with 33ppt underperformance since inception

Swaps can boost or drag long-term ETF allocations

Jamie Gordon

City night skyline emerging markets

Examining total cost of ownership reveals universal truths about investing including the fact high charges and replication costs destroy returns, especially when your ETF lags its benchmark by 33 percentage points (ppts) since inception.

This is the waking nightmare of any investor that has held the $94m Xtrackers S&P Select Frontier Swap UCITS ETF (XSFR) since inception in January 2008, with XSFR’s benchmark rising 20.4% while the ETF returned -13.3%, as at 6 June.

XSFR replicates the S&P Select Frontier index comprised of 40 of the largest and most liquid frontier market companies, weighted by market cap.

While there is a stark disparity between the ETF and its index at headline level, this tracking difference warrants some qualifications.

First, for physical exposures, sourcing the underlying assets in niche geographies can be a costly affair, however, for synthetic exposure, the cost of maintaining the swaps can accumulate over time.

This can even be seen in ETFs such as the recently launched iShares MSCI World Swap UCITS ETF (IWDS), which carries a weighted average swap fee of 0.13% without capturing emerging markets.

From a fee perspective, DWS’s XSFR carries an eye-watering total expense ratio (TER) of 0.95%, however, this is a product of the ETF’s age, with global ETFs launching a year later with fees of 0.50% – a far cry from recent launches offering global equity exposure at a TER of just 0.07%.

Overall, investors capturing frontier markets through ETFs have one option, given DWS’s product is the only vehicle offering the exposure.

A DWS spokesperson commented: “We can confirm that the performance drag is a result of the swap spread and TER compounded over the term they have stated. Creation and redemption fees do not impact the performance of the fund.

“Where the fund trades an index swap with the swap counterparty, the cost of executing that index swap is passed on to the authorised participant and thus has no impact on fund performance. This is similar to the actual cost of execution model for physical ETFs.”

However, the lesson XSFR teaches us should not be that swaps-based ETFs are inefficient vehicles for long-term asset allocation. Rather, investors need to understand the specific dynamics of the swaps-based exposure they are entering.

For example, swaps-based exposure can actually afford a performance uptick in certain scenarios, including when taking swaps-based routes to China A-Shares.

Christopher Mellor, head of EMEA ETF equity product management at Invesco, said an “interesting structural anomaly” exists, owing to the lack of a physical securities lending market for offshore investors into Chinese onshore equities, making it difficult for hedge funds to take out short positions.

Instead, those looking to short the market are forced to use an index portfolio approach comprised of swaps and pay an “awful lot” to counterparty banks, which in turn benefits ETFs which offer banks a good vehicle to offset these exposures.

In effect, swaps-based China A-Shares ETFs regularly carry negative swap fees, meaning when hedge funds are crowding to short China’s onshore market, these ETFs can receive a performance uptick as high as 16% a year, Mellor said, which also acts as a unique buffer during China equity market downturns.

The positive impact of this dynamic has seen the $1.1bn Xtrackers CSI 300 Swap UCITS ETF (XCHA) return 74.3% since inception in February 2010 versus 61.1% for its benchmark.

Elsewhere, a less temperamental advantage afforded by using swaps-based exposure is the well-trodden path of Irish-domiciled ETFs capturing US equities.

Many fund selectors will be bored of the repeated mantra that the Ireland-US Double Taxation Treaty halves the withholding tax burden on dividends paid by Irish domiciled US equity ETFs from 0.30% to 0.15% – and this is reduced to 0% for synthetic ETFs covered by the 2017 HIRE Act – but it is repeated for good reason.

Its impact can be seen across swaps-based S&P 500 ETFs offered by Invesco, BlackRock and DWS, with the latter of the trio – the $9.8bn Xtrackers S&P 500 Swap UCITS ETF (XSPX) – returning 481.2% since inception in March 2010 versus 456.2% for the S&P 500.

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