07:52 AM, 24 Feb 2017 (AUS EST)   The market is currently closed       

Physical ETFs vs Synthetic ETFs

Synthetic ETFs are hitting the news with regulatory issues and concerns. What are the benefits and risks of synthetic ETFs? Should you invest in them as opposed to a vanilla or physical exchange-traded fund?

Synthetic ETFs Explained

Physical ETFs vs. Synthetic Funds

A normal exchange-traded fund involves someone going out and buying actual shares in the market. Once the manager has enough size and appropriate weighting of shares to mirror the index, he makes creation units which represent the the total share purchase. These creation units are then split up into smaller exchange-traded fund units. In a nutshell, even though the exchange-traded fund cannot be turned in for real shares, it is based on physical shares that are held by someone, somewhere. The issuer in turn, gets management fees.

A synthetic fund is one that does not need to hold the identically matching underlying shares in support of ETF pricing. The ETF price could be artificially created through derivatives – such as options – or be swap-based, which may have a variety of collateral sources backing it.

Derivative and Swap-Based ETFs

Leveraged and inverse options usually make use of options to achieve these geared results. As an example, the fund Direxion Daily Financial Bear 3x Shares (FAZ), amplifies daily price movements of the Russell 1000 Financial Services index by 300% in the opposing direction. If you feel that the Russell 1000 Financial index will drop 3%, the fund can be expected to rise 9%. These types of funds are sometimes used for short-term hedging or for day trading purposes.

A swap-based ETF is one where you are in an agreement, or are a counterparty, to the issuer. If the issuer is a bank, then they agree to pay the difference between the buying and selling value of the ETF. The bank is not required to hold the identical companies and shares that make up the ETF.

Perks of Swap-Based Synthetic ETFs

One of the largest perks to synthetic ETFs is that they can more closely mirror the underlying index than can a traditional ETF. The swap-based ETF is not limited by the process of finding available shares which are prone to slippage. A synthetic ETF does not need to re-balancing like a traditional ETF does so that portfolio weights are correct. Low tracking error makes buying and selling ETFs more efficient

A second perk to swap-based synthetic exchange-traded funds is that it allows for a wider variety of investments. As an example, emerging markets and emerging commodities would be almost impossible to properly track with physically backed ETFs, but with synthetic ETFs this is possible.

The Downside of Synthetic ETFs

There is a dark side to ETFs though, although it may never happen. The risk involves bank liquidity. What is backing your ETF if everyone should want to cash in all at once? That is a question worth asking.

To reassure investors that they have money to cover the ETFs and that they are not using it to simply print cash, banks hold collateral as backing for the swaps. Problem solved? Not exactly. The question now is: what are the banks using as collateral?

  • Is it some illiquid asset?
  • Does it have any correlation to the ETF?
  • There could be concerns if the ETF made huge gains – did the bank make enough to cover this?
  • What if everyone panics and sells their ETFs – can the bank come up with enough capital on short notice?

Because the bank selling the synthetic ETF does not need to be in possession of the underlying asset, this could create issues in illiquid indices. As an example – imagine you could get a synthetic ETF in an index worth only $1 million dollars (not likely but this is for hypothetical informational purposes). You can purchase, in theory, and unlimited amount of synthetic ETFs. What is stopping you from buying $20 million dollars worth of synthetic ETFs, then investing another $1 million in the index constituents driving the underlying index sky-high, and then selling the synthetic ETFs back to the banks? In theory, if you can buy more ETFs than available shares, this could create a problem.

While this may not happen, it is important to remember the recent history of the credit crisis in 2008/2009 and how synthetic products can exacerbate liquidity crises.

Synthetic vs. Traditional ETFs

Clearly, synthetic ETFs are able to perform feats that their traditional counter-parts cannot. The upside includes a wider range of markets and lower tracking error. On the other hand, traditional exchange-traded funds are backed by the underlying assets. In theory, this should lower your risk of getting your money back if another liquidity problem should occur.

Whether the risks outweigh the perks is a personal decision you will need to make.