Sideshow to the mainstream
16 April 2014
Category: News, Asia, Global
By Imran Ahmed
Following the success of index ETFs, ETF firms soon added “synthetic” ETF structures to their product menu. While there are several factors involved in the development of synthetic ETFs, operational efficiency and reduced tracking error contributed to the philosophy underlying the product’s development. Some of the thinking behind synthetic ETFs is encapsulated in the phrase, “Why own the shares (securities) when the index return can be generated through a total return swap?” In addition, most ETFs that promise “leveraged” returns, e.g. double and triple negative / positive index returns, are synthetic ETFs. These ETFs generally use swap-based structures as it is virtually impossible, and typically not permitted by fund regulations, to generate two-fold (or more) returns using cash-based physical replication ETF structures.
As of February 2103, synthetic ETFs were a significant portion of ETF assets in Europe, with approximately 35% of net assets. Conversely, in the United States synthetic ETFs accounted for less than 3% of all ETF assets, according to a report from Vanguard Research in June 2013 entitled Understanding Synthetic ETFs. The main reason behind the higher percentage of synthetics in Europe is largely attributable to tax and regulatory reasons. Bank parent companies of European asset managers often derive capital and tax synergies through the total return swaps executed with ETFs managed by associated asset managers. Nonetheless, recent data indicates ETF funds, even in Europe, are shifting away from synthetic ETFs in favour of replication ETFs.
In October 2013, physical ETFs in Europe registered net inflows of US$6.4 billion versus an outflow of $2.3 billion from synthetic ETFs. Adding to the negative trend for synthetics was an announcement in December 2013 by Deutsche Asset and Wealth Management (DeAWM), Europe’s largest synthetic ETF provider, that during 2014, the firm would transform 18 of its largest synthetic ETFs to physical replication funds. The move followed a sharp drop in assets under management for DeAWM’s synthetic ETFs in the latter half of 2013. Earlier, Credit Suisse converted the bulk of its synthetic ETF structures to physical ETFs prior to the sale of its ETF division to iShares. The Credit Suisse / iShares transaction closed in July 2013, according to the Financial Times.
Synthetic ETFs “invest – or may be directed to invest by the swap counterparty – in securities (the “substitute basket” or “collateral basket”) that may be unrelated to the benchmark index and also enter into a swap agreement with one or more counterparties who agree to pay the return on the benchmark to the fund. Thus, a synthetic ETF’s return is guaranteed by the counterparty”, according to the Vanguard Research report. A total return swap is a financial derivative contract with a counterparty to pay the ETF the return generated by a specific index or basket of securities. In return, the ETF pays the counterparty a fee or a stream of cash payments during the life of the contract.
There are two main types of synthetic ETF structures, essentially differentiated by the use of either unfunded or funded swap structures. In both structures, the funded and unfunded, the counterparties to the swap are obligated to impart the index performance to the ETF’s investors.
In the “unfunded swap structure”, an ETF issues shares to an authorised participant in return for cash. The cash is used by the ETF to purchase a substitute basket of securities, also known as the collateral, from the swap counterparty. Simultaneously, the ETF enters into a total return swap with the counterparty. In the terms of the swap, the return from the basket of securities is paid to the counterparty while the counterparty pays the index return, less any applicable fees, to the ETF. Importantly, the ETF maintains title to the basket of securities.
In the “funded swap structure”, the cash obtained by the ETF is delivered to a counterparty. In lieu of the cash, the counterparty is obligated to provide the ETF with the total return on the agreed benchmark index. Concurrently, the counterparty (purchases and) hands over a basket of securities into a segregated account with an independent custodian. This collateral is often up to 120% of the cash amount and is available to the ETF in case the counterparty goes bankrupt. An important distinction in the funded model (versus the unfunded) is that title to the basket of securities is retained by the counterparty in this funded structure.
Advantages of synthetic ETFs
Synthetic ETFs have several benefits, including giving ETF manufacturers a reasonable methodology by which to track markets which may not otherwise be so amenable to physical cash-based ETFs. Some stock exchanges and bond markets are simply too illiquid for ETFs, thereby making it impossible to create appropriate portfolios to replicate the performance of a benchmark index. The illiquidity problem is compounded as an ETF gains popularity and its asset base increases.
Another advantage of synthetic ETFs lies in their ability to provide returns associated with markets that may otherwise be off limits due to specific regulatory and / or legal reasons. For example, several frontier markets impose varying restrictions on foreign investors investing in domestic stock markets. ETFs, as they are generally domiciled in international financial centres, typically fall in the foreign investor category for such markets. These impediments often circumscribe an ETF’s capacity to accurately replicate market indices. The stock exchanges of several Gulf Arab nations illustrate this point.
Operationally, too, it is sometimes easier and more efficient (often swaps reduce an ETF’s tracking error) for ETFs to enter into total return swaps rather than replicate portfolios of certain benchmark indices. In this scenario, several factors come into play. One consideration is the absolute number of companies included in an index.
Synthetic ETFs, like any other financial instrument, contain a number of risks. The prime source of concern for investors in synthetic ETFs lies in the assumption of counterparty risk. Generally there is little additional counterparty risk in the unfunded swap structure. However, investors assume significantly greater risks in the funded model.
As all of a synthetic ETF’s benchmark returns emanate from a swap guaranteed by a third-party financial institution, typically an investment bank, the ETF is subject to solvency and performance risks associated with the external firm. In other words, if for any reason the swap counterparty cannot fulfil its swap contractual commitments towards the ETF, the ETF’s investors suffer. Moreover, counterparty risk originates not only if the counterparty goes bankrupt but also if the benchmark index return is higher than the return on the basket of assets purchased for the ETF.
Collateral is the primary risk reduction mechanism for a synthetic ETF. The degree to which an ETF’s structural risk is reduced by collateral is based on several factors. The quality of securities held as collateral, particularly as these securities may differ widely from the benchmark constituents and thus possibly create a negative value gap. The liquidity of collateral securities must also be taken into account. Another factor is “over-collateralisation”, which is important as sometimes securities must be sold quickly at knockdown prices.
In the event of any default, the ETF must resort to claiming the collateral as a means to minimise the potential financial loss for investors. Once a counterparty defaults, the ETF will instruct the collateral agent to transfer all relevant assets to the ETF’s account. In the event of a counterparty’s bankruptcy, it may be the case that a bankruptcy administrator freezes the firm’s assets, invariably leading to legal complications in enforcing the pledge.
Over the years, synthetic ETFs have complemented traditional, physical replication ETFs by broadening the available menu for ETF investors. Synthetic ETFs, much like their future-based ETF cousins, played a role in helping open up certain markets previously believed difficult to access by replication ETFs. Recently, however, there has been an increased trend away from synthetic ETFs and towards replication ETFs. The tendency is understandable given the heightened awareness amongst investors of counterparty risk post the recent global financial crisis.
The financial crisis not only increased investor consciousness about counterparty risks as they relate to ETFs but also increased regulatory scrutiny of synthetic ETFs. In July 2012 an independent European Union agency tasked with protecting Europe’s financial system, the European Securities and Market Authority, issued new stricter guidelines for UCITS ETFs. Among the guidelines are enhanced disclosure requirements regarding swap counterparties, counterparty default risks as well as the degree of discretion a counterparty maintains over a portfolio. The amplified scrutiny by regulators also encourages traditional ETF structures at the expense of synthetic ETFs.
Despite the ETF sector’s rapid development during the last two decades, it remains a growth segment within the financial services industry. ETFs continue to evolve and mature in response to the twists and turns of a dynamic global economy. However, with increased investor focus on financial risk and greater regulatory constraints, the synthetic genre of ETFs is gradually becoming a sideshow to mainstream, cash-based ETFs. It is unlikely synthetic ETFs will reverse their declining share of a growing ETF market anytime soon.