The Truth about Synthetic vs. Physical ETP Flows

The "fear of synthetic" may not be enough to explain the underlying market dynamics

Jose Garcia Zarate 1 November, 2011 | 3:33PM
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To say that the ETP industry is under heavy scrutiny around the world would be a massive understatement. Perceptions about the exchange-traded-product industry have changed dramatically over the past year. International economic bodies such as the IMF or the BIS have set their sights in the fast-growing ETP market, identifying it as a potential source of “systemic risk”. We know that much of the criticism so far laid against the ETP market is actually not ETP-specific, but applicable to the mutual fund industry in general. And yet, ETPs have become something of an easy target for the regulators, perhaps on account of being a fairly new industry posting punchy growth rates and thus gnawing market share away from the “old establishment”.

For some of the ETP providers, namely those following synthetic replication methods, the accusations of unfair treatment against the industry as a whole have been compounded by the feeling that they have been specifically targeted as the most likely sources of systemic risk. And so, one key question that we need to address is whether investors are responding to these concerns by actually migrating from swap to physical ETP structures.

What the Flows Tell Us
By looking at the market flows statistics out to end-Q3, one would be very tempted to argue that they are indeed. According to estimated net flows data sourced at Morningstar Direct, swap-replicated ETPs (note – for the purposes of this article we define ETP as the sum of ETFs and ETCs) experienced net outflows of close to EUR 2.1 billion in the third quarter of 2011, while physically-replicated ETPs saw net inflows worth EUR 5.74 billion. Looking at the historical data charted in the accompanying graph, one clearly notices that the third quarter stands out as the first since 2010 that one of the two replication methods has seen net outflows.

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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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