Synthetic ETFs

Published June 10, 2011

Synthetic ETFs: knowledge is key By MICHELLE TAN POPULARISING exchange-traded funds (ETFs) seems to be one of the initiatives actively pursued by the Singapore Exchange (SGX) and global ETF sponsors as they join hands to educate the media and public on what these products have to offer. Synthetic ETFs will have its place when it comes to satisfying an investor's appetite for exposure to difficult-to-replicate physical indexes. However, like any investment, investors must do their homework. In particular, with any derivative, a little more education to the retail public would be beneficial. - Michael Chan of BNY Mellon However, the risks of ETFs are sometimes omitted at such events, making these educational efforts come across more as a sales pitch than an objective knowledge-imparting session. On the occasions when such risks were discussed, many investors still walked away as clueless as they started off due to their inability to comprehend the product and the technical lingo used. More importantly, some argue that while institutional and sophisticated investors may be equipped with the requisite knowledge and understanding of ETF methodologies to discern the benefits and downside of such products, retail investors might not possess the technical expertise to see beyond an issuer's initial marketing scheme. Furthermore, the runaway success of ETFs has led to an era of increasingly complex products using synthetic structures, placing retail investors at an even greater disadvantage in terms of comprehension. But that has not quelled the drive of ETF issuers to conjure up more synthetic products as the appeal of such ETFs far outweighs any points of apprehension, at least from their perspective. For one thing, synthetic ETF issuers are able to cut down on cost pertaining to the rebalancing of a physical portfolio and other index balances, as a synthetic ETF replicates returns via the use of derivatives, instead of a basket of physical assets. Furthermore, via the use of derivatives - such as total return swaps - synthetic-type products are able to ensure greater effectiveness in the tracking of the underlying securities, reducing overall tracking error. As such, it is no random anomaly that synthetic replication has been a key growth driver for the ETF industry over the past few years. In fact, Manooj Mistry, head of equity ETF structuring at Deutsche Bank, notes that over 50 per cent of assets under management in ETFs located in Europe are in synthetic ETFs and most new issuers are catching on fast by adopting the structure. Sceptics have, however, raised the flag as they warn against synthetic ETFs' over-reliance on derivatives in the tracking of an index objective. Notably, regulators in the US Securities and Exchange Commission (SEC) and Europe's Bank for International Settlements (BIS) have already initiated reviews in the last few months on the potential systemic risks of structured ETFs. After all, it was derivatives - in the form of credit default swaps - that crippled financial systems around the world in the fateful year of 2008, triggering one of the worst global recessions since the Great Depression of the 1930s. So it is perfectly normal - indeed, wise - for investors to practise some caution when dealing with such products. Besides, as everyone knows, there's no such thing as a free lunch in this world; good things always come at a cost. In the case of synthetic ETFs, the reduction in tracking error is exchanged for increased counterparty risk. In layman terms, counterparty risk is the probability that the total return swap provider goes bust. In the past, many would have laughed at such a thought, as counterparties were usually global investment banks that were believed to have pockets as deep as the Pacific Ocean. However, sentiment has since shifted, especially after the demise of the seemingly indestructible Lehman Brothers - which has since vanished from the face of the financial world, leaving many of its employees and investors in the lurch. In such an event, the synthetic ETF would lose its ability to generate returns, and all that investors would have to fall back upon would be collateral. But would the collateral be enough to recover all the funds an investor places in a synthetic ETF? The answer, at best, is maybe. Though in practice, excess collateral is typically used to back a synthetic ETF in times of counterparty default, there still lies the risk that the collateralised assets might not be able to be liquidated fast enough. Moreover, the longer it takes to liquidate the collateralised assets, the more likely the assets would plummet in value. In such a scenario, investors would not be able to get back the full market value of their ETF shares. So the quality of the collateral assets backing a synthetic ETF is of utmost importance, and investors should make a special effort to understand the nature of these assets before plunging into buying a synthetic ETF. Currently, a number of ETF issuers and sponsors publish their collateral policy and contents in each fund's collateral basket on the Internet for public scrutiny, although few would be able to decipher the meaning of the array of technicalities, such as product codes, so frequently used in such fact sheets. For now, there is no requirement for collateral to be held in the same securities that the ETF tracks. This suggests that a collateral basket can be filled with all kinds of controversial securities, such as junk bonds, unrated bonds and illiquid small-cap stocks - all of which would face much difficulty if there arises a need for quick liquidation. More pertinently, investors should be wary of synthetic ETFs using a funded or prepaid swap to replicate returns, as the ETF provider in such cases is not the beneficial owner of collateral assets - which implies that it can be frozen by a bankruptcy administrator in the event of a counterparty default. In such an unfortunate instance, the collateral will not be released to the ETF issuer, and some investors will inevitably be left holding the bag. All said and done, however, it's not as if synthetic ETFs should be avoided like the plague. In fact, investors who fully understand the complexities of synthetic ETFs' workings should go ahead and vest their funds in these products and capitalise on attractive features such as low management fees. On a similar note, Michael Chan from BNY Mellon reiterated: 'Synthetic ETFs will have their place when it comes to satisfying an investor's appetite for exposure to difficult-to-replicate physical indexes. However, like any investment, investors must do their homework. In particular, with any derivative, a little more education for the retail public would be beneficial.'