Can the law be separated from society
What is a special fund?
Definition - overview
Hardly a year goes by without “turbulent” events on the financial markets. Sometimes the DAX collapses, sometimes the Dow Jones and in the most extreme case there is a serious economic crisis, as in 2008, which then has global implications for investors. So, of course, investors are right to ask to what extent their ETF portfolios are subject to default risk (also known as issuer risk)? In other words, can my ETF provider file for bankruptcy and I lose my investment?
In fact, this risk does NOT exist with ETFs! Because in principle, even in the event of a financial crisis, there is no issuer risk with ETFs. As a special fund, ETFs are protected against the bankruptcy of the issuer. The term special fund describes a legal technical term. The German law, more precisely: the Capital Investment Code (KAGB) defines special assets as
„domestic open-ended investment funds in contract form that are managed by a management company for the account of the investors in accordance with this Act and the investment conditions, according to which the legal relationship between the management company and the investors is determined.”
What sounds cumbersome in the legal text is of great importance for investors: Since ETFs are set up as special assets, the investors' capital is kept in a location that is independent of the investment company. The investment capital is thus separated from the assets of the capital management company. For investors this means: Even if the investment company goes bankrupt and in the course of this has to service its creditors, the capital is - legally - protected from access by the company or that of the creditors.
A risk of failure can thus be as good as excluded. However, this only applies to full replication ETFs and not to swap ETFs, which are particularly popular with private investors. You can find out more about this below and about detailed aspects of special funds under the Investment Act.
No risk of default with full replication ETFs
The full replication ETFs, which replicate the underlying index one-to-one using the corresponding stocks or bonds, do not involve any risk of default. With them, investors only bear the market risk of the underlying index. A large ETF provider is currently even foregoing tax optimization of dividend payments with certificates for risk reasons.
Low risk of default with swap ETFs
The swap ETFs popular with private investors limit the default risk to a maximum of ten percent of the fund's assets. The UCITS-III fund guideline prescribes a maximum swap value of ten percent of the fund's assets for swap ETFs. As soon as the value of the swap agreement reaches this limit, the swap agreements are redeemed and their share is repaid. The remainder of the fund is invested in securities which, however, do not have to be included in the index.
Special assets for investment funds according to the Investment Act
The capital paid in by the investors and the securities acquired with it in the ETF portfolio form the so-called special assets. As the name suggests in principle, the collected capital is to be kept “separately”. This does not affect the fund if the values of other funds within the investment company change. On the contrary, the law clearly states: The special fund is legally protected from access by the corporation and, in the event of bankruptcy, even from its creditors.
According to Section 92 of the Capital Investment Code (KAGB), the investment fund must be kept separate and may not be liable for debts. The strict custody of the investment fund by a custodian bank protects investors almost 100% against losses by the investment company. Even in the event of insolvency, the right of disposal is legally transferred to the custodian bank. And according to § 100 KAGB, the custodian bank is then obliged to return the investment fund to the investors - according to their shares, of course.
But there is one point where the investment company has the upper hand over the custodian bank: the corporation alone determines the investment policy, i.e. it makes all investment decisions with regard to the investment fund. Even if it does not have direct access to the assets, the investment company initiates sales and purchase orders for the investment fund and merely communicates these decisions to the custodian bank. The custodian bank can then switch, buy or surrender the securities from the investment fund, but has no influence on the investment decisions of the corporation.
Since the assets of an investment fund are strictly separated from their own and other managed assets of the investment company, special funds cannot be held liable for the liabilities of the investment company. Therefore, in the event of insolvency, they do not become part of the company's insolvency estate.
In addition to the case of default by the issuer or the swap party, which has received much attention in view of the Lehman Brothers bankruptcy, investors also run the risk of the custodian bank, which holds the fund's assets, going bankrupt. Funds guarantee the legal right to separate all securities held for them from the custodian bank's insolvency estate. The default risk for ETF investors is therefore extremely low.
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