Swap-based ETFs & Index Funds

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

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

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

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

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 funds 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. 

Swap-based funds 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 funds. Some investors prefer swap-based funds 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 funds might be the most efficient way to access a particular market. 

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

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

Swap reset: A fund 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.

Swap counterparty: A bank that enters into a swap contract with the fund.

Every investment comes with risk. The primary risks of ETFs and index funds are related to the underlying market being tracked, whether the fund 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 providers like us have long found ways to mitigate this risk successfully.  We use multiple banks to back up our swap-based funds, and we ensure they are all in good financial health. 

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 swap-based funds and their swap counterparties 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 fund. 

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: A provider can choose only one or a range of counterparties to provide swaps for its ETFs and index funds. 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 funds 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.

An index fund is a type of passive investment that aims to match the performance of a market index, such as the S&P 500 or the MSCI USA. These funds typically offer low fees and may require a minimum or regular investment amount. Unlike ETFs, index funds are not traded on exchange. They are priced once a day after the market closes, and most investment platforms don’t charge dealing fees when investors buy or sell them.

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. The official overnight interest rate benchmarks used in Europe, the US, and the UK are:

• €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.

These benchmarks capture 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.