‘Dying breed’ synthetic ETFs seeing resurgence

Tom Eckett

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Over the past few years, there has been a clear trend away from synthetic ETFs, as investors prefer products where the ETF provider holds the securities instead of taking on counter-party risk.

Just six months ago, ETF Stream declared the war was over between synthetic and physical ETFs however, there are signs this could be reversing.

First brought to the European market in 2001, synthetic ETFs use derivatives such as swaps and futures contracts to track the underlying index with providers entering a deal with a counterparty that ensures returns will match the benchmark.

Up until the Great Financial Crisis in 2008, synthetic and physical ETFs, which own the underlying assets they track, saw similar flows into their products. However, the tables appeared to turn in 2011 after warnings from the IMF and Financial Stability Board, both of which were unconvinced by swaps in the aftermath of 2008.

According to Morningstar data, synthetic ETFs had around 45% of the assets under management (AUM) in Europe however, this had fallen to around 20% in 2016.

In a research note entitled Are Synthetic ETFs A Dying Breed?, Morningstar ETF analyst Jose Garcia-Zarate suggested at the time the trend was set to continue with ETF providers moving away from synthetic products.

However, synthetic ETFs have rebounded in popularity this year. According to data from Lyxor, synthetically-backed US equity ETFs have posted €730m inflows into European listed products so far this year, versus €1.49bn outflows for physical US equity ETFs.

One key driver for this shift is the asset class. Adam Laird, head of ETF strategy, northern Europe, at Lyxor, said synthetic US equity ETFs have demonstrated a “distinct” performance advantage over physical products.

One reason for this is the tracking error is more precise. Physically-backed ETFs can be impacted by trading frictions and taxes, whereas a synthetic ETF’s returns is, in theory, guaranteed by the counterparty.

“This particularly been the case in the US,” Laird commented. “Even though it is a mainstream market there are taxes and trading costs involved.”

Emerging markets is another area where flows into synthetic products has been strong. This market is an area where replication has traditionally been trickier for ETF providers due to issues around access.

Laird added there are tax barrier concerns to take into account for physically-backed funds, especially in countries such as India.

“Moreover, there is a case of ‘time heals’,” Laird continued. “There was a general sense of malaise about derivatives in the aftermath of the GFC.

“But now a decade has passed without incident, investors seem much more comfortable to analyse and use synthetic where there is an advantage.”

Futures v ETFs – the debate continues

For investors, it is a case of doing the due diligence to assess what factors such as tracking error and counterparty risk are more important to them in the respective markets.

French asset managers Amundi and Lyxor control the majority of assets in synthetic ETFs in Europe with Xtrackers, WisdomTree and iShares controlling the rest. SPDR and Vanguard do not offer synthetic ETFs.

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