Synthetic ETFs: How Protected Are You?

Investors need--and deserve--to know the identity of swap counterparties, the composition of the collateral basket and how often swaps are reset

Morningstar Europe Editor 29 July, 2010 | 10:00AM
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Since the credit crisis shook up the global financial system in 2007-2008, investors have become increasingly concerned over products using derivatives. Swap-based ETFs are no exception. The two most common criticisms of synthetic ETFs are their complexity and lack of transparency. In this article, we will try to demystify these funds and shed some light on the risks involved in investing in them.

Unlike a cash-based ETF, a synthetic ETF doesn’t hold the underlying index constituents. Instead, it holds a basket of securities which may be completely unrelated to the index it is tracking and to which investors have recourse in case of issuer’s failure. The fund typically will enter into a swap arrangement in which it gives away the performance of the collateral basket in return for the performance of the fund’s reference index. The swap counterparty is usually an investment bank.

This structure has been widely embraced in Europe because it reduces tracking error, it is lower in cost and it enhances market access. In fact, today there are more ETFs that use the synthetic replication method than those that use physical replication, although cash-based ETFs have the greater share of assets in Europe. Despite having numerous undeniable advantages, swap-based ETFs bear counterparty and collateral risks that shouldn’t be overlooked.

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Morningstar Europe Editor  .

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