Synthetic ETFs and Structural Differences

There is a variety of ways to synthetically replicate an index and investors should be aware that comparing structural risks between them is not at all straightforward

Hortense Bioy, CFA 9 June, 2011 | 3:30PM

We have many times in the past--in our reports, articles and webinars--discussed the investor protections inherent to most exchange traded products (ETPs). In my article published last July, Synthetic ETFs: How Protected Are You?, I highlighted the need for improved transparency in swap-based ETFs, especially as it pertains to collateral policies, in order for investors to fully assess the counterparty risk they face in this type of ETFs. Although its aim wasn’t to be comprehensive, that article failed to distinguish between the many structures currently employed by various providers of synthetic ETFs across Europe as well as the risks associated with them. This will be addressed in the coming weeks with the publication of a comprehensive report outlining and scrutinising all the various practices employed by swap-based ETF providers in Europe (if you are interested in receiving a copy of this report please send an e-mail to etfqueries@morningstar.com). Meanwhile, I thought I’d give our readers a sneak peak into the part of our report dealing with structural risks.

Assessing these risks is actually not as straightforward as we would have wished as the practice actually appears much more complex than the theory, hence a few misconceptions in the minds of some investors.

Given the variety of structures used to synthetically replicate an index, investors should be aware of the differences between the various legal arrangements in place as they will determine the procedure that will be followed in the event of a counterparty default. I must admit that here we are entering legal territory where we often hear that the devil is in the details.

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About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive funds and sustainability research in Europe for Morningstar

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