Talking about synthetic ETFs is likely to generate much eye rolling, but bear with me. The so-called synthetic vs physical debate, which started roughly seven years ago, was one of those necessary evils – the debate was necessary, but synthetic ETFs took the brunt of a very angry post-2008 world.
During the mud-slinging synthetic ETFs were criticised for not being collateralised enough – and when they were, could you trust the bank offering the collateral? They were too risky for retail investors because of the counterparty risk and the use of the swap was too complex for IFAs to explain and then because you didn’t hold the actual securities, they just weren’t as good as physically-backed ETFs.
The damage from the debate forced some of the big synthetic ETF providers, such as Lyxor and db X-trackers (the second and third largest providers by assets) to re-model and offer physical ETFs. Both businesses lost market share. Europe has since seen the assets split between synthetic ETFs and physical ETFs move to 20%-80%, respectively.
However, in the drama surrounding the debate the benefits of synthetic ETFs were lost.
Unlike a physical ETF whereby all securities from the index are owned, a synthetic ETF uses a swap to get the exposure and doesn’t hold the securities. ETFs buy and hold a basket of securities and at the same time enter into a swap agreement with a counterparty who commits to pay the index performance in exchange for the performance of the fund holdings. This process of using a swap is cheaper than setting up a whole eco-system to accommodate physical replication and this saving is passed on to the investor.
Synthetic ETFs have the ability to reduce tracking error, which is the fluctuation of the daily movements between the ETF and the index.
The use of the swap also means investors can access markets and asset classes otherwise close doff to them, such as commodities and some emerging markets. These can’t be accessed via physical replication because of certain complexities including foreign ownership restrictions, trade restrictions, tax issues and, in the case of commodities, investors not taking delivery of the asset.
My reason for writing this is to ask whether, because synthetic ETFs have such a bad rep, some investors are missing out on access to certain markets.
For example, markets such as India have restrictions on who can hold certain companies, by using a derivative you can get low-cost access and good performance of the whole market. The country has a fast-growing and developing economy with good supportive factors – the Indian Prime Minister declared at the 2018 World Economic Forum that the country’s economy will double to $5trn by 2025, there is also a growing middle class and money being invested in infrastructure.
Yes, Indian stocks are volatile – the MSCI India Index fell 69% in 2008 – but the annualised five-year return of the MSCI India index is 12.49%. If you want access, though, you probably have to use a synthetic ETF. The three main India ETFs in Europe all use a swap; the Lyxor ETF MSCI India C-EUR (INR) (EUR) with a TER of 0.85%, the Amundi ETF MSCI India EUR A/I (CI2) (GBP) at 0.8% and db x-trackers CNX Nifty 1C (XNID) (USD), which costs 0.65%.
The use of synthetic ETFs does open the ETF owner up to counterparty risk, but synthetic ETF providers now over-collateralise the ETF, usually at 110%, and most issuers reset the swap on a daily basis in a bid to maintain zero daily counterparty exposure.
The last time an ETF ran into liquidity issues was in 2008 when trading in more than 100 of ETF Securities AIG-linked ETCs were briefly suspended on the LSE before AIG finally posted $1.5bn of collateral.
Some synthetic providers use a multiple swap-counterparty model such as Source ETF – acquired by Invesco last year – which was owned by several banks, allowing for multiple counterparties.
A necessary debate
I don’t deny that the debate surrounding physical and synthetic ETFs was necessary. The difference between the two needed to be clearer, but I don’t agree that synthetic ETFs should have so brutally been left out in the cold. They have a role to play and it has been assumed that retail investors are unable to understand them and their risks.
We only have to look to certain countries to see that they are still popular. In South Korea synthetic ETFs are used by all investors. The most prolific provider is Mirae Asset Global Investments Co. Ltd who recently announced it had acquired ETF issuer Global X in a bid to grow its business.
Similarly, Italy is one of the biggest users of leveraged and short ETFs by retail investors in Europe. Last week the second most traded ETF on the Borsa Italiana was the Lyxor FTSE MIB Daily Double Short (XBear) UCITS ETF. It’s a synthetic ETF.
Despite synthetic advocates now expanding their physical offering, a recent survey by one ETF provider found that 27% of their investors were happy to use synthetic ETFs, while 51% were happy to use them when there was a clear benefit.
I agree that conceptually synthetic ETFs are not as easy to understand as physical ETFs, but risks are present in both, we have just assumed that retail investors won’t be able to understand them.