Update: Lyxor UCITS ETF Daily Double Short Bund

The fund can be deployed tactically as a bet against the German long-term sovereign debt market, or as a hedge against a decline in the value of German government debt. It is worth noting that using this fund as a hedge could have at least one advantage over shorting a traditional long ETF tracking the 10-year German sovereign debt market. Given its intrinsic leverage, the fund allows investors to hedge their German government debt exposure without tying up too much capital. For example, those holding a portfolio made up of 10-year German sovereign debt could effectively neutralise their daily exposure by investing only a third of the portfolio-value in this fund, while allowing investors to avoid taxes, spreads and broker fees that they would otherwise incur if they liquidated all or a portion of their portfolio. However, if held from more than one day, particularly so if the underlying market were to go up, the effect of compounding means that returns will begin to deviate from those on the long side of the position, which could severely undermine the value of the hedge. For this reason it should be emphasised that this fund is not suitable for investors seeking a medium-to-long-term position hedge. A more appropriate solution in that situation could be the short-selling of an unleveraged long ETF tracking the appropriate index, but with the inclusion of a stop-loss provision to cap potentially unlimited losses.

Fundamentale Analyse

The German government remains the chief architect of economic policy in the Eurozone. Severe budget deficit reduction strategies have been imposed at the behest of Germany on her Eurozone partners in exchange for Berlin’s support for some unpalatable compromises (e.g. sovereign bailouts and the setting up of the European Stability Mechanism). The net effect of this policy drive so far has been that of widening a growth gap between core and peripheral Eurozone economies to the benefit of the former but also forcing the latter to undertake much needed structural reforms. The export-oriented German economy posted an impressive recovery from the depths of the post-Lehman recession, and although the pace of GDP growth slowed in recent years, the basic premise of German outperformance remains solid.

Prompted by deflationary pressures – heightened since the collapse of oil prices - and anaemic growth levels experienced by the Eurozone, the ECB announced a massive quantitative easing programme in January 2015. The programme involves the buying of 60bn Euros of government bonds on a monthly basis until, at the earliest, September 2016. Full blown QE represents the latest, and most dramatic in a series of economic stimulus measures introduced by the ECB, including earlier asset buying initiatives (e.g. covered bonds) and successive interest rate cuts which have left lending rates hugging the zero bound.

Although such an enormous and sustained stimulus package is expected to boost price levels – at least in the near-term - there remain question marks over the structural stability of the Eurozone.

The potential for significant political tensions within the monetary union has resurfaced with the election of Syriza in Greece, who swept to power on an anti-austerity, debt-forgiveness ticket. The rise of similarly populist political forces in other Eurozone countries is also a cause for concern.

The ECB’s monetary activism seems to have significantly reduced the risk of contagion. However, even accounting for this, the management of the Greek situation has the potential to alter core-periphery dynamics.

Should the Eurozone core-periphery relationship strain considerably, this ETF is likely to prove to be an attractive ‘safe-haven’ investment for Eurozone fixed income investors given Germany’s dominant role within the EMU.

Alternatively, in the event that QE does provide stability and boost price levels, due to its mandate, the ECB will be obliged to raise rate in response. If administered indelicately, this could prompt a stampede of investors exiting their fixed-income positions. Under these circumstances, this ETF could be used tactically to profit from the associated fall in bond prices. However, at present this scenario remains a very distant prospect.

Indexkonstruktion

The Societe Generale Index Daily Double Short Bund index, created and disseminated by S&P, offers exposure to a double short strategy on a portfolio of German government bonds, with an average maturity of 10 years on daily basis. In order to achieve this, the index combines a long position in a daily overnight investment at the EONIA rate along with a double short position in EUREX Bund Futures contracts closest-to-expiry. The leveraged position in the relevant EUREX Bund Futures contract is rolled to the next contract series on each roll date, which is the first business day immediately preceding the last trading day of each EUREX Bund Futures contract series. The process of rolling futures contracts exposes the investor to roll yield (i.e. return generated based on price differences between the expiring contract and the next contract). However, given that the index rolls into the closest-to-expiry contracts, the roll yield should be a relatively small contributor to the return of the index. Therefore, as a recap, the return of the index will be composed of three parts: i) performance of the double short position in the EUREX Bund Futures contracts, ii) EONIA interest rate, and iii) the roll yield. Investors should keep in mind that this index only aims to deliver the inverse 2x performance on a daily basis for the 10 year German government bonds. Over time, it is very likely that this index will diverge from inverse 2x performance due to the effects of compounding.

Fondskonstruktion

In order to provide the index return to investors, Lyxor enters into an un-funded swap agreement with Societe Generale. Under the agreement, the fund uses investors’ cash to buy a substitute -basket of EUR-denominated fixed income securities, both government-backed (e.g. sovereign, regional, agency) and corporate. Societe Generale then commits to deliver the performance of the reference index, less swap fees, in exchange for the performance of that basket. While Lyxor is a wholly owned subsidiary of Societe Generale, it does follow the best execution principle laid out by the European Markets in Financial Instruments Directive. In doing so, Lyxor challenges Societe Generale’s swap prices by putting the bank in competition with other external swap providers. If an external provider offers a better price, Societe Generale will match that swap price. Lyxor has a daily target of zero counterparty exposure, which means that swaps are reset whenever their marked-to-market value becomes positive. In practice, we find that swaps tend to have a negative value (between -2% and 0%), which is equivalent to an over- collateralisation of the funds. A negative swap value means that the fund owes the counterparty money. Lyxor does not engage in securities lending for its suite of synthetic ETFs.

Gebühren

Lyxor charges a total expense ratio (TER) of 0.20% for this ETF. It should be remembered that there are additional, investor-specific costs associated with trading the ETF, such as bid/offer spreads and brokerage commissions, which should be factored into an investment decision. As this fund uses synthetic replication there are additional swap-costs which must be borne by the investor.

Alternativen

As we write, the Lyxor Daily Double Short Bund ETF is the most popular ETF in the European market, as measured by assets under management, offering daily double short exposure to the performance of the German government bond market.

The ComStage Commerzbank Bund-Future Double Short TR UCITS ETF (TER 0.20%), which tracks a proprietary index, offers similar exposure.

Even more adventurous investors might wish to consider the Boost Bund 10Y 3x Short Daily which also offers short bund exposure but with a higher degree of leverage. It should be stressed that due to the elevated risks associated with all leveraged products, they should only be used by highly sophisticated investors.