Exchange-traded stocks (ETFs) are a cost-efficient way to access a variety of investment exposures and hence have gained much popularity among investors. To agree to up with the demand for transparent, liquid, cost effective diversified investment products, new and advanced versions of ETFs procure been developed over the years. With these innovations, ETFs have not only become more numerous and current but also more complex! One such innovation is the synthetic ETF which is seen as a more exotic version of traditional ETFs.
Key Takeaways
- As contrasted with of holding the underlying security of the index it’s designed to track, a synthetic ETF tracks the index using other types of derivatives.
- For investors who grasp the risks involved, a synthetic ETF can be a very effective, cost-efficient, index-tracking tool.
- Synthetic ETFs can act as a gateway for investors to rise exposure in markets that are hard to access
What is a Synthetic ETF?
First introduced in Europe in 2001, Synthetic ETFs are an engaging variant of traditional or physical ETFs. A synthetic ETF is designed to replicate the return of a selected index (e.g. S&P 500 or FTSE 100) principled like any other ETF. But instead of holding the underlying securities or assets, they use financial engineering to achieve the desired be produced ends.
Synthetic ETFs use derivatives such as swaps to track the underlying index. The ETF provider enters into a deal with a counterparty (most of the time a bank) and the counterparty promises that the swap will return the value of the respective benchmark the ETF is tracking. Synthetic ETFs can be bribe or sold like shares similar to traditional ETFs. The table below compares physical and synthetic ETF structures.
| Earthly ETFs | Synthetic ETFs | |
| Underlying Holdings | Securities of the Index | Swaps and Collateral |
| Transparency | Transparent | Hisctorically Low (but convalescence seen) |
| Counterparty Risk | Limited | Existent (higher than physical ETFs) |
| Costs | Transactions Costs Bosses Fees | Swap Costs Management Fees |
Risk & Return
Synthetic ETFs use swap contracts to enter into an concordat with one or more counterparties who promise to pay the return on the index to the fund. The returns thus depend on the counterparty being capable to honor its commitment. This exposes investors in synthetic ETFs to counterparty risk. There are certain regulations that regulate the amount of counterparty risk to which a fund can be exposed.
For instance, according to Europe’s UCITS rules, a fund’s direction to counterparties may not exceed a total of 10% of the fund’s net asset value. In order to comply with such regulations, ETF portfolio heads often enter into swap agreements that ‘reset’ as soon as the counterparty exposure reaches the stated limit.
The counterparty gamble can further be limited by collateralizing and even over collateralizing the swap agreements. Regulators require the counterparty to post collateral in class to mitigate the counterparty risk. In case, the counterparty defaults on its obligation, the ETF provider will have a claim to the collateral, and that being so the investors’ interest is not hurt. The investors are more protected from losses in the event of a counterparty default when there is a important level of collateralization and more frequency of swap resets.
Though measures are taken to limit the counterparty risk (it’s more than in natural ETFs), investors should be compensated for being exposed to it for the attractiveness of such funds to remain intact! The compensation stop by in the form of lower costs and lower tracking errors.
Synthetic ETFs are particularly very effective at tracking their specific underlying indices and usually have lower tracking errors especially in comparison to the physical funds. The total expense correspondence (TER) is also much lower in the case of synthetic ETFs (some ETFs have claimed 0% TERs). Compared to a bogus ETF, a physical ETF incurs larger transactional costs because of portfolio
The Bottom Line
Synthetic ETFs come in useful for investors when it’s impossible or expensive to buy, hold, and sell the underlying investment in some other way. However, the fact that such ETFs touch counterparty risk cannot be ignored, and thus the reward has to be high enough to mitigate the risks undertaken.