DIY Investor Magazine
/
December 2015
54
WHAT ARE SYNTHETIC ETFS FOR?
But synthetic ETFs don’t work this way often because
the markets they track are very hard to physically
recreate at a reasonable cost; a market may consist
of many small and illiquid securities that are very
expensive to trade or complexities of tax, time zones
and local laws may make it difficult to track some global
indices.
You would expect an index tracker to actually invest in the same holdings as its index. This is how a
physical ETF works and why it returns the same results as the market it mimics.
HOW A SYNTHETIC ETF REPLICATES ITS INDEX
In the case of commodities it would be inconceivable
to take delivery of thousands of cows because you
wanted to track livestock so a synthetic ETF uses a total
return swap instead of physical holdings to earn the
return of its index.
A total return swap is a derivative contract provided by
a counterparty such as a global bank or other large
financial institution whereby the counterparty pays the
ETF the return of the index it tracks including dividends
in exchange for a fee and the investment return of
collateral posted on behalf of the ETF.
Collateral is used to mitigate the possibility of investors
losing out if the counterparty defaults on its obligation
to pay, which exposes synthetic ETFs to some
counterparty risk which investors should understand.
Cash invested in the ETF secures a basket of securities
that form its collateral, and this would be sold and the
proceeds used to return the investor’s money if the
counterparty were to default.
Collateral is often held in securities completely
unrelated to the market the ETF follows - a FTSE All-
Share synthetic ETF may hold some of its collateral in
bonds or Japanese equities!
UCITS ETFs (those approved and regulated by EU
rules) are not allowed to expose more than 10% of
their Net Asset Value (NAV) to counterparty risk and
many providers apply even stricter criteria and ‘over
collateralise’ so that the ETF is protected by collateral
worth more than 100% of its NAV.
Synthetic ETFs have been subject to a great deal of
scrutiny from the media and regulators which has
led providers to spread the risk by using multiple
counterparties, increase the quality of collateral and
revalue it daily in order to ensure that it is 100% of NAV,
thereby reducing counterparty risk.
Synthetic ETFs have two main advantages over
physical versions.
Firstly, synthetics provide a low cost way to access
certain niche markets that would otherwise be off-limits
to most investors.
Secondly, they can sometimes undercut their physical
rivals in certain markets with lower Ongoing Charge
Figures (OCFs) and tracking error because they avoid
the complexities of trading the securities of the index.
Your broker should allow you to screen the products on
its platform by replication method, or you can use the
Screener at
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ETFS AT A GLANCE
