Etfs Swap: A Comprehensive Guide to Investing

ETFs swap, also known as exchange-traded funds, are a popular way to invest in the stock market with flexibility and low costs.

They offer a wide range of investment options, from stocks and bonds to commodities and currencies.

Investing in ETFs can provide diversification, which can help reduce risk and increase potential returns.

You can trade ETFs throughout the day like individual stocks, making it easy to adjust your portfolio as market conditions change.

ETFs are often less expensive than actively managed mutual funds, with lower fees and expenses.

Their transparency and liquidity make them an attractive choice for many investors.

Broaden your view: Stocks vs Etfs

ETFs work by using a swap agreement to track the performance of an index. This agreement is between the ETF provider and a swap counterparty. The ETF provider pays out the return it earns from a basket of securities to the counterparty, who then pays the index's return to the ETF.

Discover more: Asset Swap

The ETF holds and retains control of the basket of securities, even if the counterparty defaults. The ETF's exposure to its swap counterparty is usually limited to 10% of the ETF's net asset value. This means the ETF could lose up to 10% of its net asset value due to unpaid obligations from the swap counterparty.

Direxion rebalances exposure daily by buying or selling swaps to ensure that each fund tracks as closely as possible to its benchmark index's daily performance.

Broaden your view: Real Asset Etfs

A Total Return ETF is not the same as a swap-based ETF, which doesn't own any shares or bonds.

Normally, when you invest in a TSX 60 ETF, the ETF takes your money and invests it in actual companies like RBC and Shopify.

Total Return ETFs, on the other hand, aim to track the total return of a specific index, which includes dividends and capital gains.

A big shout out to Dan Bortolotti and Dr. Mark Soth for their work in fleshing out the details on swap ETFs, which have helped create unique products like those from Horizons.

Curious to learn more? Check out: Swap Ratio

ETFs come in different structures, each with its own way of working. There are two main types of swap-based ETFs: unfunded and funded.

In an unfunded swap model, the issuer creates new shares of an ETF in exchange for cash from the authorized participant. The provider uses the cash to buy a basket of assets from the swap counterparty in exchange for the rights to the gains generated by the benchmark index.

The funded swap model operates similarly, but the collateral basket is placed into a separate account rather than the ETF. This means the collateral doesn't have to track the benchmark index, and the asset classes included in the collateral can differ from the benchmark.

Here are the key differences between unfunded and funded swap-based ETFs:

In a funded structure, the ETF passes its cash holdings to a swap counterparty in exchange for the returns of the index the ETF is tracking. The swap counterparty will post collateral with a third-party custodian to offset the ETF's exposure.

Take a look at this: What Is Share Swap

There are several types of ETFs that cater to different investment goals and risk appetites.

Index ETFs track a specific market index, such as the S&P 500, allowing investors to gain broad exposure to the market.

Actively managed ETFs, on the other hand, are run by a professional manager who actively selects securities to include in the fund.

Sector ETFs focus on a specific industry or sector, such as technology or healthcare, providing targeted exposure to a particular area of the market.

Synthetic ETFs are a type of investment vehicle that invests in derivatives and swaps rather than physical stock shares. They aim to match the performance of a benchmark index, but without owning any physical securities.

The first synthetic ETF was introduced in Europe around 2001, and it remains a popular investment in European markets. However, only a small number of asset managers in the US issue synthetic ETFs due to regulations enforced by the US Securities and Exchange Commission in 2010.

Intriguing read: Usd Currency Etf

Synthetic ETFs are riskier structures than physical ETFs because investors are exposed to counterparty risk, as concluded by a 2017 Fed study. This means that if the counterparty defaults on its obligations, the ETF will suffer a direct loss.

There are two main types of synthetic funds: unfunded and funded. In an unfunded swap model, the issuer creates new shares of an ETF in exchange for cash from the authorized participant. The provider uses the cash to buy a basket of assets from the swap counterparty in exchange for the rights to the gains generated by the benchmark index.

In a funded swap model, the collateral basket is placed into a separate account rather than the ETF. More importantly, the collateral does not have to track the benchmark index, although it is often highly correlated.

Here are the key differences between unfunded and funded swap models:

Synthetic ETFs have been used to access restricted markets, such as China or India, through participatory notes (P-notes) or other derivative products. This structure has been used for indices on restricted markets, and the risks include counterparty risk and potential losses if the collateral is liquidated under adverse market conditions.

For another approach, see: Leveraged Emerging Markets Etf

Direxion Leveraged and Inverse Funds are designed to seek daily leveraged investment results, before fees and expenses. They aim to magnify the returns of their benchmark indexes, or provide inverse exposure to them, for a single day.

These funds are available in both bull and bear varieties, with the bull funds seeking 300% or 200% of the performance of their benchmark index, and the bear funds seeking 300%, 200%, or 100% of the inverse of the performance of their benchmark index.

To obtain the necessary exposure, Direxion Daily Leveraged ETFs invest in derivatives, such as swaps or futures, which provide the ability to gain exposure to indexes and sectors without full dollar-for-dollar investment.

The Bull Funds generate between 10% and 100% of their requisite exposure level from equities and the remainder from derivatives. The Bear Funds generate their entire -100%, -200%, or -300% exposure through derivatives.

Direxion Leveraged and Inverse ETFs come in 2X and 3X varieties, which means each dollar invested provides $2 or $3 of the performance of the benchmark, resulting in 200% or 300% (or -200% or -300% for leveraged Bear Funds) of the risk and volatility.

There is no guarantee that the funds will achieve their investment objective, and returns for periods greater than a day are a product of the compounded daily leveraged returns during the period.

For your interest: List of Direxion Etfs