Assessing the merits of physical and synthetic ETFs

Physical

Nick Good

Managing director, head of iShares, Asia-Pacific

Amid all the recent attention on exchange traded funds (ETFs), the clearest voices have been those calling for increased simplicity and transparency, along with improved risk protection for investors. While certain types of synthetic ETFs should heed these calls, simplicity and transparency are already defining features of physical ETFs.

Stating the case for physical ETFs is straightforward. Physical ETFs were designed to be easily understood by the person on the street. They are simple and transparent and where this is a combination that yields effective results for investors, there is no need for investors to look to synthetic options.

Physically-backed ETFs do what they say on the label: they closely replicate an index by holding the underlying securities. These securities are exchanged between the ETF manager and participating dealers to allow the creation or redemption of units in response to shifting demand from investors. In contrast, many synthetic ETFs are collateralised by equities that have nothing to do with the index.

Physically-backed ETFs are transparent because they tell investors what’s inside: the underlying securities held by the fund are fully disclosed daily. Physical ETFs also provide a transparent relationship between the fund and independent participating dealers. With synthetic funds is it not always clear what underlying investment is made, nor is it always clear what conflicts of interest may exist between the manager and the counterparty.

Arguments against physical ETFs overlook some key factors. Claiming some physical ETFs carry more tracking error than synthetic ETFs disregards the comfort given to investors by knowing they have invested in a vehicle making real trades in real securities to generate real returns. Arguing against securities lending in physical ETFs overlooks the risk framework surrounding the activity. A successful securities lending programme can deliver significant returns, while maintaining a low risk profile.

We are already observing many investors reverting from synthetic to physical ETFs. This is likely to increase as awareness grows of the conflicts of interest inherent in the vertically integrated model used by most investment banks that offer synthetic ETFs. Under this model, different arms of the issuing bank act as both the synthetic ETF manager and the swap counterparty that commits to pay the return of a particular index. This approach has been criticised by bodies such as the Financial Stability Board for being deeply conflicted.

However, not all synthetic ETFs are in this boat. While physical ETFs offer an investment that is simple and transparent, where physical replication cannot be effectively achieved, such as in China, synthetic ETFs using multi counterparties have a role. Synthetic ETFs that use multi counterparties give investors access to hard to reach markets while meeting the same high fiduciary standards enshrined in physical ETFs. This is achieved by using different parties to act as the ETF manager and the swap counterparty, reducing risk. Having multiple swap counterparties gives the ETF provider the flexibility to quickly change exposures if there were concerns about a possible credit-event.

Collateral requirements for synthetic ETFs recently announced by the Securities and Futures Commission in Hong Kong are a sensible development, which we fully support.

We expect economic growth and increased capital market openness in Asia to allow the development of more products employing physical replication. Investors should look for vehicles – physical ETFs where possible and synthetic ETFs using multiple counterparties where physical investment is not an option – offering diversification, liquidity, transparency, cost-effectiveness and trading flexibility from an ETF provider that has a fiduciary obligation to act in the best interests of their clients.

Synthetic

Marco Montanari

Head of db X-trackers ETFs and db-X funds, Asia, Deutsche Bank

Over the past months, there has been widespread discussion on ETFs, with focus placed on comparing synthetic and physical ETFs, as well as an evaluation on the respective risks. The recent regulatory change announced by the Securities and Futures Commission in Hong Kong in enhancing the collateral requirements of domestic synthetic ETFs further extends this discussion.

A key advantage of ETFs adopting synthetic replication is that they are designed to track an underlying index with minimal tracking error. Under this methodology, the market sees new innovative and efficient index tracking solutions made available globally, allowing for a greater range of ETFs available for investors’ choice over the past years.

Recent discussions outline the fact that synthetic ETFs are prone to potential counterparty risk, leading to doubts over the structure’s reliability. This is not the whole story – when investors take a closer look, they will be able to find synthetic ETF providers that are committed to creating investment products that meet the highest levels of transparency and structural robustness. On the other hand, ETFs that adopt “direct replication” may also possibly involve counterparty risks, even if it holds the constituent securities of the underlying index. This is due to the potential security lending activities that may take place. No matter what structure an ETF adopts, due diligence work by the investor is key.

For ETFs using “synthetic replication” to track the index, one way this could be done is for the ETF to gain exposure to an underlying index through an index swap with one or more swap counterparty(ies). This is one of the most effective ways of tracking an index due to the minimal tracking difference and costs and at times is referred to as “next generation tracking”.

Traditional ETFs, on the other hand, track an index by directly purchasing all, or a representative sample, of the constituent securities of the underlying index. Traditional ETFs have to bear the risk that their product will not precisely track the underlying index due to factors such as periodic index rebalancing costs and the timings of dividend payments. In this case, the next generation tracking method effectively outsources this risk to a third party, removing it from the investor.

Another key part of the new regulation is the requirement of publishing the latest collateral management policy on the respective synthetic ETF provider’s website on an ongoing basis, which is in addition to the current requirement to make overall collateralisation levels and other collateral information available on the respective synthetic ETF provider’s website. With the enhanced level of transparency, this would be positive in helping investors conduct their due diligence when considering synthetic ETFs.

Particular synthetic ETF providers have already begun providing information for investors with high transparency. Investors can now go online to access the most up-to-date details on the size of the swap counterparty exposure as a percentage of net asset value of a specific ETF from some synthetic ETF providers. Some websites even provide investors with a detailed breakdown of the respective collateral by security type, country, sector, currency and, for bonds, credit rating. Sometimes the full collateral composition list is available for download.

With increasingly more information provided by synthetic ETF providers for investors in a clear layout at a simple click, transparency of synthetic ETFs has been taken to a new level. With these steps in place, the ETF industry will likely continue its path on strong and robust growth, ultimately bringing more creative investment possibilities to investors in an efficient and transparent manner.