One of the benefits of the 1OAK multi-asset funds is that they combine ETF’s with Swaps to implement the investment strategy where there are clear and obvious benefits. The MA80 fund has recently entered into a swap with UBS to gain exposure to equity markets and core Government bonds. Using a swap can reduce costs and improve performance.
What are the benefits of using a swap?
Under the terms of the fund, it receives the “excess return” of the assets in the swap and pays a replication fee. When funds use a swap, it is sometimes be referred to as synthetic replication. It is a technique used by some index funds and ETF’s and widely used by smart-beta funds and others that follow a quantitative strategy.
Institutional funds will combine holding physical assets with the use of swaps or futures; however, there are relatively few retail multi-asset funds that have the flexibility to use swaps where it is beneficial.
We described how synthetic replication works and discussed the benefits of using a swap in a note we published last year. <click here> The main benefits are:
- Withholding tax benefits in some markets. Withholding taxes are a tax on dividends. There are some markets, notably US equities, where withholding taxes are not applied to investors in an “index”. This benefit is priced into the swap and means that the total return from synthetic replication can be higher than the return from holding the underlying assets directly. This can be observed directly by comparing the returns from synthetic US equity trackers to those holding physical assets.
- Eliminate the costs and charges of investing in another fund. There are already synthetic ETF’s for most of the assets where there are advantages from using a Swap. By having a swap directly with UBS, the fund can accrue the benefits without incurring the costs of investing in another fund.
- Reduce brokerage costs: The replication fees paid by the fund to UBS are typically less than the brokerage costs and other charges incurred by a fund when they buy and sell the underlying assets.
- Add value through the cash portfolio. When the fund uses a swap, there is no exchange of principal. Instead, the fund retains the cash and invests this to generate a floating return. 1OAK has developed a disciplined cash management strategy that generates LIBOR, covers the replication fee and offers an additional return for investors.
Is synthetic replication risky?
The short answer is no. However, as with any investment, there are elements of synthetic replication that are potentially risky. The key is to recognise these risks and implement strategies that mitigate the risk.
The main risk is that UBS defaults. This is unlikely; UBS are a very large systemically important bank with a high credit rating. What residual risk remains is covered by the collateral agreement. Under the terms of the swap, any exposure to UBS will be covered by cash collateral.
Is the swap as liquid as an ETF?
Swaps offer comparable or even better liquidity than physical investment because they tap directly into the vast, liquid futures markets. The fund can add to the swap and reduce investment at any time throughout the day. The returns from the swap reference the price of liquid futures contracts and total return indices.
How is the cash portfolio invested?
One of the concerns with the first wave of synthetic funds is that they used complicated derivatives to generate a floating return. These arrangements can be bundled up as a funding swap. The funding swap converted the return from a basket of assets into a floating rate. The fund would have no exposure to the performance of the basket. Although the fund can use a funding swap when the returns are attractive, our preference is to hold a basket of cash funds and other very low-risk funds. The cash portfolio is managed using tightly defined investment guidelines that adds to the overall return that the fund offers while minimising the risk to capital.
1OAK focus on using efficient portfolio management techniques to improve performance, reduce costs and enhance liquidity. Synthetic replication is one of the essential tools that 1OAK use as a manager. There are direct benefits from lower costs and reduced withholding tax and indirect benefits from managing the cash portfolio. The 1OAK funds have pioneered the combination of direct investment and synthetic replication for retail multi-asset funds, bringing benefits that have hitherto been the preserve of institutional investors to the retail market.