Are 'synthetic' ETFs worth the risk?

The press and regulators are really getting their teeth into synthetic' exchange-traded funds (ETFs) just now. Should retail investors be worried?

In a traditional ETF, the fund buys the shares or bonds underlying the index and holds them. This is so-called physical', in-kind' or in specie' replication. In the synthetic, or swap-based, version, the ETF buys a basket of stocks or bonds that are unrelated to the index being tracked. It then buys a swap contract from a counterparty, usually a bank. The swap guarantees the return on the index the ETF is meant to track (after costs). The basket of assets backs the ETF in case the counterparty fails to meet its promise.

Nearly two-thirds of Europe's ETFs now follow the synthetic route. Under Europe's fund rules (UCITS), the maximum exposure to a swap counterparty is 10% of a fund's net asset value. So at least 90% of the ETF's value has to be collateralised (backed by assets). If the counterparty defaults, the fund manager can take the basket of assets and sell it, returning a large part of the fund's pre-default value to investors.

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But if the fund's basket of holdings is topped up less frequently, consists of illiquid assets, or is uncorrelated with the index being tracked, then it's fair to worry that the shortfall could be higher. Do note, however, that counterparty and collateral risks aren't unique to synthetic ETFs. If a physically backed ETF (or any traditional fund for that matter) lends out its holdings (to short-sellers, say), that incurs risks too.

So why use swaps? In theory, synthetic ETFs can track better than physical ones can. But regulators have also noted that synthetics offer banks a way to obtain funding for their less liquid assets. So a bank has an economic incentive to place lower-quality assets in an ETF as backing for the fund's promises. Thus investors' interests may not be aligned with those of the bank-owned issuers of such ETFs.

That said, there's been commercial pressure on ETF providers to improve the quality of the backing they give their synthetic ETFs, and to improve levels of disclosure. Now several ETF providers publish details of fund assets on a daily basis and it's normal for funds to exceed the 90% minimum regulatory level of backing. So I don't believe the sale of synthetic ETFs to retail investors should be restricted. But investors should read issuers' websites carefully to find out who they are dealing with and favour the most transparent synthetic providers.

Paul Amery edits www.indexuniverse.eu .