While some investors may be wary of the risks associated with synthetic exchange-traded funds (ETFs), these ETFs can be a highly valuable tool for investors, says Morningstar’s director of ETF and closed-end fund research, Scott Burns.
In particular, synthetic ETFs are generally more effective at tracking their respective indices and tend to have lower tracking errors compared to their counterparts: physically-replicated ETFs. Synthetic ETFs also generally have much lower total expense ratios (TERs), with some ETFs even boasting 0% TERs. (In fact, as outlined in an ETF article by Alastair Kellett, the db x-trackers EURO STOXX 50 ETF (DBXE) has waived its TER entirely.)
However, concerns about counterparty risk tend to hold investors back from considering synthetic ETFs, says Burns. Investors not only have to think about investment risk (whether the ETF will go up or down in value), they also have to worry about counterparty risk. But this counterparty risk is generally blown out of proportion, says Burns. This same kind of counterparty risk exists in many other kinds of funds for individual investors, but it’s simply not discussed as much, he says.
“This isn’t systemic risk, no more than what is out there in other investments, in particular structured products,” he said. “Using a broader comparison of what is out there for investors, a synthetic ETF is more liquid, more collateralised and more transparent than other structured products.”
The conclusion? Synthetic ETFs can be a very effective, very low cost, index tracking tool, but investors must simply be sure to complete their due diligence before making an investment. Investors must understand the risks before taking the plunge. They may realise that taking on counterparty risk results in a better return, which balances the risk-return trade-off, says Burns.
Burns was speaking at the sixth annual Morningstar Investment Conference in London.
For more information about synthetic ETFs, read "Synthetic ETFs Under the Microscope: A Global Study".
