In what has been a communication war between some of the largest ETF providers, the issue of physical versus synthetic replication has left investors with more questions and suspicion than clear responses. However, to focus on the above would be narrow minded when choosing the right investment for your portfolio.
Both As Questionable As Each Other?
It was first argued that synthetic replication could bring about potentially adverse effects through counterparty risk exposure. The counterparty is the financial institution sitting at the other end of the total return swap, which is used to exchange the returns from a basket of securities with the returns of the index. Many investors had no idea that their delta one exposure, a mutual fund tracking a broad index, could involve counterparty risk. However, that risk can be partially or fully mitigated by the use of collateral.
But as a result of this synthetic scaremongering, the emphasis fell on physical replication, which in itself was a clever marketing game. Managers often improve performance of physical ETFs through stock lending programs. There used to be only partial clarity on how much of those proceeds were paid to the fund and how much to the manager, and all the while the investor was still exposed to counterparty risk against the financial institution to whom the securities are lent.
What was supposed to be simple – achieving exposure to an index with a perfectly secure vehicle such as a tradable fund on exchange – turned out to be an example of complex financial structuring.
The Saga Continues
What happened next did not help. Synthetic providers started competing with each other to implement swap resets more frequently, hence reducing the nominal exposure to the financial counterparty of the swap, while ETF sales teams were trained to offer reassurance to investors over stock lending’s counterparty risk with terms like “overcollateralization”, “fully or unfunded swap arrangements” and “collateral transparency” in carefully designed PowerPoint presentations that even experts can be baffled by.
Where does of all of this leave investors? We now see some investors, consultants and brokers making bold decisions on what form of ETF is most appropriate, closing the door to a large part of the available funds on the market. Those decision are often driven by sentiment or a very legitimate desire not to invest in what one does not understand. These decisions might, however, be slightly restrictive and prevent investors from making the optimal choice.
Ultimately, investors should simply assess a fund by studying the risk/return tradeoff. This includes the possible risks from the fund setup and replication mechanism.
Are you willing to make that call? It is worth noting that some very large ETF providers do not require the use of derivatives or stock lending programs to be efficient when operating on a very large scale and on very liquid underlying securities.
Watch Out For Smaller Funds
Here comes the trick. The proliferation of new ETFs tracking specialized indices such as sector, country or alternative weighting schemes have resulted in less scale benefits and higher trading costs. This is where stock lending helps by tilting the returns of the portfolio and possibly offsetting those costs, or where synthetic ETF managers pass the implementation complexity over to large trading organizations. It remains the investor’s role to assess whether the circumstances really justify such methods and whether the legal and operational setup offer the right level of protection.
So, how can investors make an informed choice about which ETF they should pick?
- Assess replication performance for all funds tracking a given index by analyzing the tracking error, tracking difference and their evolution over time.
- Sort funds based on what really matters to you: long term holders might be more affected by poor tracking difference while traders might fear tracking error and trading costs.
- Make certain you understand the consequence of a credit event on your assets (what assets will be returned to the fund, and what the impact of the default is). While the likelihood of such an event remains extremely low, investors will make a better decision when such a risk is factored into their selection process.
Taking into account the above wish list, the question is not whether a fund is physical or synthetic, or whether it is involved in stock lending schemes – it is simply a question of what you can get versus the risk you are taking.