Swap-based ETFs under scrutiny

Regulators and investors alike are seemingly wary of swap-based ETFs. Yet the cited risks may be overblown and are not unique to these products. Helen Fowler reports

The first synthetic ETF was created in 2001 and was hailed as an innovative index product that mitigated tracking error. A decade later, these swap-based funds have suddenly caught the attention of regulators.

In April, the Financial Stability Board warned synthetic products could be a “powerful source” of systemic risk, and said the growth of the industry warrants greater attention from supervisory bodies. Soon after, the International Monetary Fund released its Global Financial Stability paper, expressing concerns about the risks involved with synthetic replication and securities lending.

Investors also remain wary of ETFs that rely on swaps, according to research by Morningstar. Many are so suspicious they even refuse to use products underpinned by swaps and other derivatives. The survey found a third of professional investors were unsure about investing anywhere in the ETF market because of the risks involved in swap-based products.

Of those investors who have taken the plunge and are investing in ETFs, almost three quarters (74%) prefer physically-replicated funds, also known as in specie ETFs, which invest in the underlying index’s constituents. Only 8% are opting for synthetic versions.

More than a third (35%) described the distinction between swap-backed and physical replication as ‘very important’. Almost half (46%) said it was ‘somewhat important’, while only 5% claimed it was ‘not at all’ important.

The distinction between swap-based ETFs and physical products is more than academic, as Morningstar research reveals. Both products are ETFs, meaning they track chosen benchmarks, trade on exchanges, offer transparency, real-time values and function like funds. Yet, the similarities end there.

A synthetic ETF uses swaps, amounting to no more than 10% of the NAV under Ucits rules, to generate the performance of its chosen index. For added security, the product invests the remaining assets in collateral. This collateral usually takes the form of equities or bonds held as a guarantee against the swap counterparty going under or failing to honour its side of the agreement.

Structural differences
The set-up on a physically-backed ETF differs in several key respects. There are no swaps or derivatives involved in generating the performance. The provider actually holds the underlying securities in the chosen index – although it may hold only a representative sample.