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
Facebook Twitter LinkedIn

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.

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

To view this article, become a Morningstar Basic member.

Register For Free

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Morningstar Europe Editor  .

Audience Confirmation


By clicking 'accept' I acknowledge that this website uses cookies and other technologies to tailor my experience and understand how I and other visitors use our site. See 'Cookie Consent' for more detail.

  • Other Morningstar Websites
© Copyright 2021 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Cookies       Modern Slavery Statement