Swap-based ETFs

There are two ways an ETF can replicate the performance of an index, either through physical or swap-based replication. Depending on the particular index being tracked, one method might have advantages over the other. 

Physical replication: The ETF tracks the index by buying and holding a portfolio of securities that closely matches the index’s composition. When the index rebalances, the ETF will need to buy or sell securities so that it continues to resemble it. There are two ways a physical ETF may invest:

• Full replication – The ETF holds all of the securities in the index in the same proportions as they appear in the index.
• Sampling – The ETF holds a sample of securities from the index that are expected to perform similarly to the actual index.

Swap-based replication: The ETF also buys and holds a basket of securities but not necessarily those of the index being tracked. The ETF will aim to deliver the index performance through a financial agreement (swap contract) provided by an investment bank (counterparty).

Swap-based ETFs aim to deliver precise tracking, as the swap counterparty is contractually obliged to match index performance, helping keep costs low and predictable. They also benefit from favourable tax treatment in the US and UK, potentially offering a performance edge over physically replicating ETFs. Some investors prefer swap-based ETFs for precise market targeting. 

While there's no definitive right or wrong way to replicate an index, the choice often depends on the index itself. In some cases, swap-based ETFs might be the most efficient way to access a particular market. 

Even though the securities are different from those in the index, they’ll still be expected to generate a return. Of course, on any given day, the return could be more or less than the index return.

Swap-based ETFs contract with one or more banks to exchange the performance of their basket for the performance of the index (plus or minus a fee) using what’s known as a ‘swap contract’. This contractual agreement means that the swap-based approach is likely to be able to track an index more closely than a physical approach.

Every investment comes with risk. The primary risks of an ETF are related to the underlying market being tracked, whether the ETF is tracking an index through physical or swap-based replication methods. Having a counterparty involved, however, presents an additional risk. Counterparty risk means there is always a chance, however remote, that a counterparty fails. But ETF providers like us have long found ways to mitigate this risk successfully. 

We use multiple banks to back up our swap-based ETFs and we ensure they are all in good financial health. And, when you’re talking about banks as big as JP Morgan.

Our swap-based ETFs use an agreement/contract where two parties agree to exchange cashflows. They use total returns swaps, where the ETF exchanges the total return on its portfolio of assets for the total return of the relevant index.

The swap fee is the all-in amount paid by the fund to the counterparty for the service of replicating the index return.

An ETF and its swap counterparty are required to ‘reset’ the swap agreement - and settle the difference – if the value owed to either party exceeds a specified amount.

A bank that enters into a swap contract with the ETF. 

The possibility that the bank (swap counterparty) is unable to honour its agreement to pay the index performance to the ETF. 

• We accept only quality securities in the basket: We choose what securities are accepted into the fund basket and what is deemed unsuitable. You can find the basket of securities for each fund, on the product pages of our website.  
• We reset the swaps frequently: Our ETF and its swap counterparty are required to ‘reset’ the swap agreement – and settle the difference – if the value owed to either party exceeds a specified amount. We endeavour to reset the swaps within tight trigger values; a policy designed to further limit the amount any swap counterparty can owe the ETF. 
• We regularly assess and monitor swap counterparties: We apply strict financial assessment criteria when considering any counterparty and continually check each chosen counterparty to ensure it remains in a healthy financial position to meet its obligations. 
• We use multiple counterparties: An ETF provider can choose only one or a range of counterparties to provide swaps for its ETFs. We use multiple counterparties as it helps diversify the risk of being over-reliant on a single bank and should reduce the financial impact if one on those counterparties is unable to fulfil its obligations.
• Most of the fund value is in the fund basket: Our swap-based ETF owns a basket of equities which accounts for the vast majority of the fund value. The only time that the fund has exposure to the swap counterparty is if the index being tracked performs better than the basket held by the fund.

These are investment products that aim to deliver returns based on overnight interest rates – typically used for short-term cash management and capital preservation, especially in volatile markets. 

These are official overnight interest rate benchmarks used in Europe, the US, and the UK. They reflect the cost of very short-term borrowing between banks and other financial institutions, and are considered reliable indicators of central bank policy and market liquidity:

• €STR (Euro Short-Term Rate) – Set by the European Central Bank, it shows the average rate at which banks lend to each other overnight in euros.
• SOFR (Secured Overnight Financing Rate) – Based on actual transactions in the US Treasury repo market, it’s widely used as a benchmark for US dollar-based products.
• SONIA (Sterling Overnight Index Average) – Published by the Bank of England, it reflects overnight lending rates in British pounds.