Synthetic ETFs Under the Microscope

Exchange-traded products (ETPs) have recently been subjected to a greater level of scrutiny. The rapid growth in these various investment vehicles has been accompanied by an increasing level of complexity in both how they are structured and the underlying exposures they seek to achieve. In the wake of the global financial crisis, it is understandable why regulators might view such a rapidly expanding and innovative niche within the financial markets with caution. However, increased regulatory scrutiny could ultimately stifle the development of a product that is in many regards far safer, more transparent, and less costly than many competing investment vehicles. ETPs’ low costs, generally stable and transparent portfolios and liquidity make them useful tools for a very wide spectrum of investors. But as with any investment vehicle, there are risks entailed in investing in ETPs, and it is vital that investors understand these risks.

The aim of this report is to illuminate the key risks, risk mitigants, and rewards associated with synthetic replication ETFs. After closely examining the practices of each of Europe’s largest providers of swap-based ETFs, we have produced a general list of best practices for investors to use as a guide in assessing these various providers’ practices. We also provide a detailed explanation of the mechanics of the two basic swap models used by providers of synthetic ETFs in Europe: funded swaps and un-funded swaps. Additionally, we have produced comprehensive profiles of each of the providers of swap-based ETFs in Europe. Here, we closely examine the most crucial aspects of these providers’ product structures: the identity of the swap counterparty(ies), the fund holdings/collateral baskets, swap reset policies, disclosure levels, securities lending policies, and swap costs.

Executive Summary
-- Exchange-traded products (ETPs) have recently been subjected to a greater level of scrutiny.
-- The rapid growth in these various investment vehicles has been accompanied by an increasing level of complexity in both how they are structured and the underlying exposures they seek to achieve.
-- In the wake of the global financial crisis, it is understandable why regulators might view such a rapidly expanding and innovative niche within the financial markets with caution.
-- Exchange-traded funds (ETFs) using synthetic replication techniques have been at the epicenter of the most recent round of high profile warnings on the risks associated with ETPs.
-- This structure contains some unique sources of risk. In assessing the risks associated with these structures it is important to address three key questions:
1. What is the source of the risk?
2. How are investors being protected against this risk?
3. How are investors being compensated for assuming this risk?
-- Investors in swap-based ETFs face the risk that the fund’s swap counterparty will default on its obligation to provide the return of the fund’s reference index.
-- There are a variety of risk mitigants employed by providers of synthetic ETFs to protect them from this risk.
-- In general, investors are compensated for assuming this risk in the form of lower holding costs relative to physical replication funds.
-- As it pertains to the value of these funds’ collateral or substitute baskets: the higher the level of these baskets’ value relative to the funds’ net asset value, the better.
-- Cost aspects aside, the use of multiple swap providers seems to offer better protection to investors as it ensures diversification of counterparty risk.
-- Great progress has been made as it pertains to the transparency of providers’ collateral and/or substitute baskets, mainly due to investor pressure on ETF providers. A handful of swap-based ETF providers are now disclosing snapshots of their substitute/collateral baskets on a daily basis on their websites and more providers have recently said that they will follow suit.
-- ETF providers apply very different sets of criteria for the securities they accept into their structures, with some providers being more conservative than others.
-- We have come to the conclusion that no ETF provider scores highly or badly on all aspects. We believe that as for everything, it’s all about trade-offs. Providing extra protection to investors, more often than not, results in additional costs. This in turn is reflected in the performance of the ETF in the form of negative tracking difference between the return of the index and that of the fund. Ultimately, it’s up to investors to decide the right balance between protection and return. And for that they need to do proper due-diligence. While the research burden lies with the investor, ETF providers can lighten it by being fully transparent about their practices and the various risks associated with them.