Tuesday, August 18, 2009

The rise of synthetic ETFs

Leveraged, inverse and commodity ETFs have drawn criticism of late on account of their tendency to incorrectly track the indices and benchmarks they are at first-sight structured to follow.

While professional investors might understand and even expect this sort of mis-performance due to a better understanding of ETF methodologies, the thinking is that retail investors might not be financially sophisticated enough to see beyond the initial marketing point.

All that said, consensus seems to suggest the above problem is only really applicable to more exotic ’structured’-product ETFs, not plain vanilla equity tracking funds.

Yet perhaps there is one area of concern even within the traditional ETF sphere: the rise of synthetic structures.

Manooj Mistry, head of equity ETF structuring at Deutsche Bank picks up on the point in a recent piece printed in the 2009 Handbook of World Stock, Derivative & Commodity Exchanges.

The appeal of synthetic structures to ETF issuers is obvious. They cut down on the costs of having to manage dividends, the reweighting of indices and other index rebalances or corporate actions. Accordingly, using swaps makes for much more efficient tracking as the below chart makes abundantly clear. This, of course, is a definitive winner for retail investors.

Tracking error comparison - synthetic ETF vs traditional ETF - World Exchange Handbook

As Mistry notes (our emphasis):

An index swap structure typically benefits a fund compared to owning the underlying equities due to the fact that the returns are based on the benchmark index. Effectively, the index swap ensures that the ETF will have performance, before any management fees, at least matching the designated index. In essence all the risks and costs associated with running an ETF based on equities and measured against a total return benchmark are passed onto the provider of the OTC swap. This means that a synthetic replication ETF, by the very nature of the returns that it now receives, is likely to be considerably more efficient than one based on the standard structure running the full basket of underlying equities.

Using OTC swaps to achieve synthetic replication, meanwhile, offers clear advantages over futures, which generate ongoing costs with respect to futures roll, margins, execution risk and relatively high tracking errors.

Accordingly, it’s no surprise that synthetic replication has been a key driver within the industry for the last few years. So much so Mistry notes in Europe over 50 per cent of assets under management in ETFs are in synthetic replication ETFs and most new providers are adopting the structure.

However, there is one issue. Retail investors are now incrementally more exposed to OTC counterparty risk.

Note the following blurb in a FAQ from Societe Generale’s ETF business Lyxor International Asset Management, which uses synthetic replication for all its ETFs (our emphasis):

What is synthetic replication? Synthetic replication involves the use of derivatives and is the latest technology available for benchmark replication. The increasingly popular use of synthetic replication in passive management is made possible by recent relaxation in regulatory restrictions on general use of derivatives and the advancement of derivative innovation, such as equity-linked swaps (”ELS”), which can give precise and pre-determined performance. With synthetic replication, the Manager receives perfect benchmark performance from the counterparty (i.e. the ELS issuer) and thus can guarantee near perfect performance (before fees) and low tracking error (after fees) for the fund. However, it is also subject to counterparty risk. Should the counterparty default, the investment objective may not be achieved.

So, that’s more unregulated counterparty risk - just what we all need, right?

Of course, counterparty risk can and is offset or managed via the use of credit derivatives. It can also be priced into the ETF units themselves — but that does has the potential to impact tracking efficiency.

Then there’s the daisy-chain of risk created, something Shah Gilani at Money Morning draws attention to in his rather scathing account of the ETF industry this month (our emphasis):

Then there’s the multiplier effect — a “daisy chain” of risk. When a “synthetic” obligation is created, it exposes the contracted party to risk. To mitigate that “paper” — but very real — risk, another derivative is often created to offset the initial contract risk, and then sold to another counterparty. Wall Street loves ETF products because they have created another separate profit center for the insiders to rape and pillage. The cover is often explained as a healthy arbitrage that keeps the EFT universe of instruments trading near their net asset values. While that’s true, it’s a built in goldmine for the Street, which when it becomes tilted away from them will cost the markets and our faith in them to once again crumble.

Meanwhile, on the matter of how ETFs are actually geared more towards professional investors than retail ones, he notes:

When the shares of an ETF trade, for any number of reasons, at a discount or premium to their net asset value, or NAV, the APs rush in to “arbitrage” the difference. Buying or selling shares, and swapping them out on the other side to the ETF sponsors, theoretically drives the ETF price closer to NAV. There are billions of dollars to be made — chiefly by insiders, or those connected to insiders — in this exercise, which is why it’s become a business in and of itself. The more ETFs there are, the more locked-in arbitrage opportunities there are for the insiders. It’s brilliant. The problem, not just because I didn’t think of it, is that is skews trading-volume figures, creating a false sense of liquidity — and with that a false sense of safety. Credit Suisse Group AG (NYSE ADR: CS) now estimates that ETFs account for a quarter of U.S. equity volume.

Definitely food for thought.

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