Understanding Synthetic ETFs and Their Risks

Synthetic ETFs can be a complex and intimidating investment option, but understanding the basics can help you make informed decisions.

They are created using derivatives, such as options or futures contracts, to replicate the performance of an underlying asset.

Here's the thing: synthetic ETFs don't actually hold the underlying assets, which can be both a blessing and a curse.

This means they can be more flexible and easier to trade than physical ETFs, but it also raises some significant risks.

One of the main risks is counterparty risk, which occurs when the issuer of the derivatives used to create the synthetic ETF defaults on their obligations.

ETFs, or Exchange-Traded Funds, are a type of investment fund that's traded on a stock exchange like individual stocks. They allow you to buy and sell a diversified portfolio of securities, such as stocks, bonds, or commodities, with a single investment.

Physical ETFs are the original type of ETF, and they hold the underlying securities or assets that make up the fund. This makes them transparent, as you can see exactly what you own.

Synthetic ETFs, on the other hand, use financial engineering to replicate the performance of an index, rather than holding the underlying securities. This can be a more complex and opaque process.

The table below compares physical and synthetic ETF structures, highlighting some key differences:

Physical ETFs are generally considered to be a more straightforward and transparent option, while synthetic ETFs offer a more complex and potentially riskier alternative.

So, how do ETFs work? Essentially, an ETF provider enters into an agreement with a financial institution, known as the counterparty, which is usually a bank.

The agreement is in the form of swap contracts, where the counterparty agrees to pay the ETF provider the total return of a pre-decided index. This means the counterparty pays both the share price appreciation and dividend payments of the index.

For example, if the chosen index is the FTSE 100, the counterparty pays the ETF provider the amount the FTSE 100 has appreciated by, as well as the equivalent of all the dividends paid out in that period by companies on the index.

The ETF provider enters into an agreement with a financial institution, called the counterparty, usually a bank. The counterparty agrees to pay the ETF provider the total return of the pre-decided index.

This total return includes both the share price appreciation and dividend payments of the index. So if the chosen index is the FTSE 100, the counterparty pays the ETF provider the amount the FTSE 100 has appreciated by, as well as the equivalent of all the dividends paid out in that period by companies on the index.

Synthetic ETFs use financial derivatives and swap agreements as their underlying mechanisms to gain exposure to the returns of a chosen index or asset. These derivatives generate cash flows that mimic the performance of the index.

To determine if your ETF is synthetic, look at the ETF's "Key Investment Document", or KID, which is a document that ETF providers are legally required to provide.

ETFs can be used for short selling and leverage, but the availability of such ETFs depends on the specific fund's investment strategy.

You can use both synthetic and physical ETFs for short selling and leverage. Keep in mind that the specific fund's investment strategy will determine what options are available.

Leveraged or inverse ETFs can be used to achieve a specific investment goal. This can be a powerful tool for investors who want to maximize their returns.

The key is to carefully consider the investment strategy and the specific ETFs available before making a decision.

Synthetic ETFs have some notable advantages. They can represent niche indexes, making it easier to access assets that are hard to access through an exchange.

Synthetic ETFs also track the performance of an index very precisely, with a low tracking error. This is because they don't need to constantly buy and sell securities, which leads to transaction costs and increases the tracking error.

Synthetic ETFs are often cheaper to run, making them a potentially more cost-effective option.

Synthetic ETFs are often preferred by investors because they can replicate the return of an alternative asset or a less liquid index with the use of swap contracts.

This method allows for a more accurate tracking of the index, resulting in a lower tracking error compared to traditional ETFs.

Synthetic ETFs typically have a lower tracking error, meaning you're likely to get a return closer to the index it's tracking.

The difference may be small, but over time it adds up, making synthetic ETFs a more attractive option.

One of the benefits of synthetic ETFs is that they can be cheaper to run, potentially making them an even more affordable investment option.

Synthetic ETFs have a low tracking error, which means they track the performance of an index very precisely. This is because they don't have to constantly buy and sell securities, unlike physical ETFs.

One of the biggest advantages of synthetic ETFs is that they can represent niche indexes for assets that are hard to access via an exchange. This opens up investment opportunities for investors who may not have been able to access these assets otherwise.

Synthetic ETFs are exposed to counterparty risk, which means there's a risk that the other party to the contract may cease to fulfill their side of the bargain. This risk is not solely dependent on the actual value of the asset, but also on the counterparty.

Synthetic replication has clear structural advantages over physical replication for some benchmarks, resulting in material performance gains versus the index. This is especially true for the MSCI World Index, which covers a large number of stocks and countries.

Synthetic ETFs often have a lower tracking error than physical ETFs, which means investors are likely to get a return closer to the index they're tracking. This can add up over time and make a big difference in investment performance.

Synthetic ETFs are often cheaper to run than physical ETFs, which is one of the big draws of ETFs in general. The synthetic method helps to potentially make them even cheaper.

Synthetic ETFs, like any investment, come with their own set of risks and considerations. Counterparty risk is a major concern, as it's the risk that the counterparty (usually a bank) won't pay up. According to Europe's UCITS rules, a fund's exposure to counterparties may not exceed 20% of the fund's net asset value.

This risk can be mitigated by collateralizing and overcollateralizing swap agreements, but it's still a risk that investors should be aware of. Regulators require counterparties to post collateral, which can help protect investors in case of a default. However, the risk is still there, and investors should be compensated for it.

Synthetic ETFs have lower costs and tracking errors compared to physical ETFs, but they also come with higher capital gains tax rates in some cases. This is because the use of financial derivatives can trigger short-term capital gains, which are taxed at higher rates. In contrast, physical ETFs can be structured to avoid taxable events, making them more tax-efficient.

Synthetic ETFs come with their own set of risks and considerations. One of the main concerns is counterparty risk, which is the risk that the bank in the swap agreement will not pay up. This risk is real, as shown by the 2008 financial crisis when some banks failed.

Counterparty risk can be mitigated by collateralizing and overcollateralizing swap agreements. Regulators require counterparties to post collateral, which protects investors' interests in case of a default. In fact, a study by the Federal Reserve in 2017 found that synthetic ETFs were overcollateralized by an average of 2%.

Regulators have specific concerns about synthetic ETFs, particularly related to the use of derivatives and counterparty risk. As a result, synthetic ETFs may be subject to additional disclosure and oversight requirements to ensure investors are informed about the risks involved.

Synthetic ETFs are generally considered to be less risky than physical ETFs, with lower tracking errors and lower costs. However, this comes at the cost of higher counterparty risk. Investors should carefully weigh these trade-offs before making a decision.

The European Securities and Market Authority requires that a fund's exposure to counterparties may not exceed a total of 20% of the fund's net asset value. To comply with this regulation, ETF portfolio managers often enter into swap agreements that "reset" as soon as the counterparty exposure reaches the stated limit.

Tax considerations for ETFs can be complex, and it's essential to understand the differences between synthetic and physical ETFs.

Synthetic ETFs may be treated similarly to other investment vehicles for capital gains taxes, but the use of financial derivatives can result in higher capital gains tax rates in some cases.

Short-term capital gains from certain derivatives may be taxed at higher rates than long-term capital gains, which can be a significant concern for investors.

Physical ETFs, on the other hand, can be structured in a way that avoids triggering taxable events due to an in-kind exchange.

Synthetic ETFs artificially generate dividend income, which may have a different tax status depending on the instruments used to generate it.

Dividend income from physical ETFs is usually classified as ordinary dividend income.

Synthetic ETFs may require tracking a higher amount of information for tax reporting purposes, which can be time-consuming and complex.

Physical ETFs with traditional structures often have more straightforward reporting requirements that exclude the need to track derivative agreements.

Synthetic ETFs can have an up-front cost advantage due to exemptions from certain taxes, such as UK Stamp Duty and financial transaction taxes in France and Italy.