An investigation of the Exchange Traded Fund: With a special focus on the swap-based structure

David Vissinger

Student thesis: Master thesis


The Exchange Traded Fund is an index-based financial product that emerged in the early 1990’s and has experienced explosive growth and media attention in the new millenium. The goal of this master thesis is to present all relevant features in this product and analyze its tracking ability compared to competitive index instruments in the European market. Furthermore, the swap-based Exchange Traded Fund is presented and its attractiveness for institutional investors is determined. Basically, the Exchange Traded Fund is a mutation between the closed-end and open-end structures known from traditional mutual fund investing. The basis for its attractiveness is a combination of the flexibility of exchange trading and the price efficiency of investment funds. The special structure is bound together by a unique creation and redemption process with dedicated market-makers linking the fund to investors in a secondary market. The construction of the product gives good terms for keeping operating expenses low. In turn, this leads to relatively low management fees. Asset allocation is the most important investment strategy for institutional investors in this product. But it is also used for cash management, hedging and arbitrage. The relevant alternatives to the Exchange Traded Fund are index-tracking mutual funds, index futures, index swaps and to some degree also direct investment in the index constituents. Institutional investors in Europe seem to have a preference for index futures in evaluating the tracking and cost efficiency of these index products, even though they are inferior to Exchange Traded Funds on longer investment horizons and require more management resources. Growth in the European market has too a high extent been driven by the success of the swap-based Exchange Traded Fund, where the index performance is delivered by the swap counterparty. This has the advantage of lower tracking error, but they also have lower costs than the cash-based funds. On the other hand, and this in spite of that the counterparties in the market must be considered very secure, counterparty risk is an inevitable part of swap contracts. Based on risk and return relative to MSCI World, the swap-based fund is attractive relative to the alternatives, but the spreads involved in trading the funds make them more suited for investments longer than a year. Important to note is that also the qualitative characteristics often is determining for the choice between a swap-based Exchange Traded Fund and one of the alternatives.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2009
Number of pages109