Evolution of Swap Based ETFs_SNUGLIFAD_0810_EN

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Evolution of Swap Based ETFs_SNUGLIFAD_0810_EN

3 The Evolution of Swap-Based ETFsThe mechanics of physical-based ETFsAn important feature of physical-based bond and equity ETFs is thatthey hold all, or a substantial part, of the index constituents in thefund’s underlying basket. The investor is then exposed to the returngenerated by the underlying basket of assets, adjusted for costs andrevenues (taking into account factors such as the total expense ratio(TER) and the addition of any securities lending revenue). Dependingon the benchmark, complexity, breadth of holdings, liquidity andease of access to the underlying securities, physical-based fundscan be either fully replicated or optimised.A fully-replicated fund structure is normally used for blue-chipdeveloped market benchmarks, such as the FTSE 100, EURO STOXX50 or S&P 500. The stocks included in these indices are typicallyliquid and easy to access and normally the ETF holds all the stocksin the weighting defined by the index. This is shown in Figure 2.The optimisation approach is typically used for very broad indiceswith a large number of constituents (i.e. Barclays Capital EuroAggregate Bond Index with close to 3,200 bonds) or those indicestracking illiquid stocks or bonds, where full replication would beeither difficult or costly and inefficient (i.e. MSCI Emerging MarketsIndex). This is shown in Figure 3.In both of the above examples, the fund’s assets are held in aring-fenced segregated account or a ring-fenced fund company,which eliminates fund/issuer risk.There is a high level of transparency with physical-based ETFs, whichis widely cited by investors as a major advantage. The ETF’s portfoliois typically fully disclosed on a regular basis and can be easilycompared to the corresponding index constituents.Figure 2: Simplified example of a physical-based, fully replicated ETF structureIndex returnIndex returnCashSecurity ASecurity AETF investorIndex returnFully-replicatedETFSecurity BSecurity CIndexSecurity BSecurity C– Costs + RevenuesSecurity DSecurity DSource: BlackRock. For illustrative purposes only.Figure 3: Simplified example of a physical-based, optimised ETF structureCashIndex returnSecurity AIndex returnSecurity ASecurity BETF investor Optimised ETFSecurity BIndexIndex returnSecurity C– Costs + Revenues~Security CSecurity DSecurity ESecurity FSource: BlackRock. For illustrative purposes only.www.iShares.com • ISHARES

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