It is the nature of ecosystems that evolution leads to complexity. As with natural selection in biology, so with the world of ETFs. As the market has grown – some might say ballooned – so the nature of the products available has evolved to include more innovative and varied funds to cater for the increasing demand from sophisticated investors.
Such as how the debate regarding physical versus synthetic replication can be viewed; the complexity represented by synthetic ETFs are a product of a vibrant ETF market overall. In 2013, research from Vanguard and based on Morningstar figures suggested synthetic ETFs were worth over a third of the total market. That proportion has almost certainly risen in the intervening period.
They were introduced into Europe in 2001 and their success in part is driven by regulatory and taxation factors. Notably, in the US swap-based ETFs come under a less favourable tax treatment than traditional ETFs, helping to explain why synthetics only account for less than 3% of net ETF assets in the US.
The prime reasoning behind using synthetics structures is that it allows providers to offer exposure to markets that are hard to access or to follow strategies that are not easily implemented. This might be related to equities in emerging markets or, as with bond markets, it may be judicious to use synthetic structures when there might be a proliferation of illiquid securities.
To add to the complexity, synthetic ETFs can then be broken down into two forms, both funded and unfunded.
A vital element of synthetic ETFs is counterparty risk. Investors in physical funds have the reassurance that the portfolio of securities is held in a segregated custody account.
Synthetic ETF investors, on the other hand, have access to the collateral or substitute basket of securities in the event of a failure but if the benchmark index’s return is higher than the return of the substitute basket over a specific time period covered by the swap, investors are exposed to counterparty risk for that difference should the counterparty not honour its commitment to the fund.
Exposure is, however, limited by UCITs regulations which limits counterparty risk to 10% of the fund’s net asset value. Hence, ETF managers generally enter into swap agreements that ‘reset’ when counterparty exposure reaches some stated limit and (as per regulatory guidance) best practice is to reset swaps daily. Over-collateralisation can also be reduced but even with these measures, counterparty risks can exist beyond the potential for default.
Counterparties can, in certain circumstances, terminate swap agreements early or seek to pass along additional hedging costs or costs can increase due to new agreements.
Given the counterparty risk involved in synthetics, why should investors consider using them. There are two main reasons:
Costs – The TER of synthetics tend to be lower than with physical ETFs. Portfolio rebalancing due to changes in a benchmark index will involve trading costs that erode an ETFs returns, albeit it helps a fund do a better job of matching an index’s return. The need to rebalance is eliminated in synthetic ETFs, since they do not physically track the index, in the sense that they do not trade the actual securities underlying an index.
Moreover, a degree of counterparty risk can be introduced to a physical ETF via funds looking to earn extra income via the practice of lending out the underlying securities to other market participants in return for collateral. After transaction costs it is common for physical ETFs to trail the return of the index by more than the TER.
Tracking error – There can be a significant difference in tracking errors between physical and synthetic ETFs – 0.06% versus 0.53% according to Morningstar figures from 2013. This is in part due to the optimisation employed by many physical funds – the further the portfolio is from full replication, the more likely will be the variability of returns. With a synthetic fund, on the other hand, because it is guaranteed by the counterparty, errors caused by a lack of full replication are not an issue. However, the terms of the swap contract are subject to change and the renewed terms could involve differing counterparties and different costs.
The complexity of synthetic ETFs has obviously caught the eye of the regulators, particularly in the US. In Europe, the European Securities and Markets Authority (ESMA) has published guidelines on ETFs and other UCITS issues. Among the body’s key stipulations are that total-return swaps or similar derivatives should extensively disclose information regarding the swap counterparties, the risks of counterparty default and the extent to which the counterparty has discretion over the investment portfolio.
ESMA also stipulates that collateral should be highly liquid, valued at least daily and independent from the counterparty and, in the case of physical stock lending, all revenue, net of operation costs, should be returned to the fund.