Morningstar calls for greater transparency

Synthetic ETFs have grown ever more complex in how they are structured and in the underlying exposures the funds aim to achieve. All of which has caused these investment products to be subjected to increasing levels of scrutiny.

MorningStar has put the market under the microscope and in publishing its findings on the unique sources of risk synthetic ETFs’ structure carries, three questions are addressed: what is the source of the risk? How are investors being protected against this risk? And, how are investors being compensated for assuming this risk?

Several factors have prompted MorningStar’s probity including the nervousness of regulators in the wake of the global financial crisis towards this rapidly expanding and innovative niche that ETFs occupy within the financial markets. ETFs using synthetic replication techniques have been at the epicentre of the most recent round of high profile warnings on the risks associated with ETPs.

This latest research highlights how investors in swap-based ETFs face the risk that the fund’s swap counterparty will default on its obligation to provide the return of the fund’s reference index. However, there are a variety of risk mitigants employed by providers of synthetic ETFs to protect them from this risk. In general, investors are compensated for assuming such risk in the form of lower holding costs relative to physical replication of funds.

MorningStar goes on to highlight in its research summary further elements of risk mitigation noting that as it pertains to the value of these funds’ collateral or substitute baskets - the higher the level of these baskets’ value relative to the funds’ net asset value, the better. Cost aspects aside, the use of multiple swap providers seems to offer better protection to investors as it ensures diversification of counterparty risk.

Where progress has been made it is noted and in particular as it pertains to the transparency of providers’ collateral and/or substitute baskets, mainly due to investor pressure on ETF providers - a handful of whom are disclosing snapshots of their substitute/collateral baskets on a daily basis.

This research found that ETF providers apply very different sets of criteria for the securities they accept into their structures. As might be expected, some providers proving to be more conservative than others.

In conclusion, MorningStar confirms that it finds no ETF provider scoring highly or badly on all aspects. “We believe that as for everything, it’s all about trade-offs. Providing extra protection to investors, more often than not, results in additional costs. This in turn is reflected in the performance of the ETF in the form of negative tracking difference between the return of the index and that of the fund. Ultimately, it’s up to investors to decide the right balance between protection and return. And for that they need to do proper due diligence.

“While the research burden lies with the investor, ETF providers can lighten it by being fully transparent about their practices and the various risks associated with them.”

www.morningstar.co.uk