Understanding the Risks of Different ETF Structures

Investing always means taking risk in the expectation of a reward; we take a look at the counterparty risks specific to synthetic and physical exchange-traded funds

Jose Garcia Zarate 10 June, 2013 | 2:07PM
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The strong growth of the Exchange-Traded Fund (ETF) market in Europe over the past years has resulted in an increasing level of scrutiny by regulators, research bodies and media commentators. This growing level of scrutiny has proved something of a double-edged sword. On the plus side, it is an explicit acknowledgment that the notion of “passive investing” is gaining ground amongst investors. However, in many instances the ETF industry has been unfairly singled out for issues - mainly pertaining to risk - that do really affect the investment fund industry as a whole. 

Whether active or passive, investing always means taking risks in the expectation of a reward. Reduced to their simplest expression we can identify two broad categories of risk, namely investment and structural. Investment risk relates to the market performance of the asset, while structural risk relates to the product used to invest in the asset. Investment risk is unavoidable, but taking on structural risk should be a matter of personal choice. 

In Europe, the debate about structural risk in ETFs has always been entwined with that about replication methodology. There are two strands of ETFs in the European marketplace: physical ETFs, which replicate the index they track by physically holding all, or a representative sample, of the index constituents; and the so-called “synthetic” ETFs, which deliver the index performance via a swap contract. 

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About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe

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