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Are Synthetic ETFs a Dying Breed?

The number of synthetic ETFs available for sale still amply surpasses the number of physical counterparts, but investors have shown a clear preference for physical replication

Jose Garcia-Zarate 25 October, 2016 | 11:06AM

Not that long ago it was hard to talk about ETFs and not get embroiled in heated discussions about the merits – or otherwise – of physical and synthetic replication. The debate was actively encouraged by ETF providers themselves. They soon realised that their infighting was detrimental for an industry in its early stages of growth, and agreed a truce. For the past few years, public confrontations about replication methodology have been largely avoided. However, the debate has had significant consequences.

There are instances where physical replication remains technically or financially unfeasible

According to Morningstar data, the split in assets under management between physical and synthetic exchange-traded-products – we include exchange-traded-commodities (ETCs) here – has shifted from 55%-45% in 2011 to just shy of 80%-20% nowadays. The number of synthetic products available for sale still amply surpasses the number of physical counterparts, but investors have shown a clear preference for physical replication.   

And so, an interesting question for observers of the European ETF marketplace is whether synthetic replication has become a dying breed.

Synthetic replication entails the use of derivatives – for example, swaps and futures contracts - to deliver the market performance of a benchmark.

The trend looks biased for a further decline for the synthetic side of the equation, as former advocates of the model continue to announce plans to expand their physical offering, whether by means of launching new products and/or switching the replication methodology of existing funds.

Lyxor and db x-trackers have long been engaged in transition efforts, while Amundi recently announced plans to open up its almost wholly synthetic ETF line-up to physical replication.

These providers have taken a pragmatic business decision, but one that implicitly acknowledges that the qualitative issue of how ETFs are put together plays has played a much more important role in investors’ decision-making process than initially envisaged.

Besides, the notion of using derivatives as the most optimal technical option to replicate the performance of hard-to-reach market areas – for example, emerging markets – or to bypass potential liquidity issues – for example in fixed income – has been increasingly undermined by the arrival of new ETFs and/or success of existing ones covering those markets and doing it physically.

So, is the synthetic replication model destined to disappear?  The answer is “not entirely”.

There are instances where physical replication remains technically or financially unfeasible. Take the case of non-metal commodities, where the cost of storage – not to mention the perishable nature of some – would always call for the usage of futures contracts to replicate their market performance.

This, however, is a largely accepted fact that does not give us a true measure of the survival chances of the synthetic replication model, which most people identify as the use of swaps. In order to assess those chances, one has to look at the areas of equity and fixed income.

It would be unwise to make the blanket statement that all ETF investors are synthetic-averse. Some feel truly at ease with the technicalities, and are willing to assume swap counterparty risk for what they consider to deliver more accurate tracking.

Ultimately, however, the way the ETF market has evolve does augur too well for synthetic replication. Synthetic ETFs may not disappear from the scene. However, one gets the sense that from a marketing standpoint they are being increasingly treated as secondary options. The conceptual simplicity of physical replication seems to have won the day.

This article was originally published in Investment Adviser

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About Author Jose Garcia-Zarate

Jose Garcia-Zarate  is a senior ETF analyst with Morningstar Europe.