How Synthetic ETFs Differ from Other Types of ETFs

The Hidden Complexity Behind Synthetic ETFs

At first glance, synthetic ETFs may seem like any other exchange-traded fund—a basket of assets that provides exposure to a particular index, sector, or commodity. However, beneath the surface lies a completely different mechanism. Unlike traditional ETFs, which directly hold the assets that they aim to track, synthetic ETFs use derivatives, particularly swaps, to replicate the performance of an index.

The Swap Agreement: The defining characteristic of a synthetic ETF is its reliance on swap agreements with financial institutions, such as investment banks. Through these swaps, the ETF manager doesn’t buy the actual securities but enters into a contract with a counterparty who promises to deliver the index's performance in return for a fee. This setup allows the synthetic ETF to mirror the returns of the targeted benchmark without holding the actual assets.

Counterparty Risk: One of the critical differences and risks associated with synthetic ETFs is counterparty risk. Because synthetic ETFs depend on a third-party institution to honor the swap agreement, there's a risk that this counterparty could default, especially during financial turmoil. Traditional ETFs, by holding the physical securities, do not face this specific risk.

Collateralization: To mitigate counterparty risk, synthetic ETFs often use collateral to secure the swap. However, the quality and liquidity of this collateral can vary, creating potential issues for investors. If the collateral falls in value or isn’t sufficiently liquid, the synthetic ETF could face problems fulfilling its obligations.

Cost and Efficiency: A Double-Edged Sword

Synthetic ETFs are often marketed as being more cost-effective than their traditional counterparts. Without the need to buy and manage the underlying assets directly, synthetic ETFs can reduce transaction costs and sometimes track their benchmarks more accurately. However, these cost benefits come with caveats.

Lower Tracking Error: Traditional ETFs can suffer from tracking errors due to factors like dividend timing, rebalancing, and the costs associated with managing the fund. Synthetic ETFs, on the other hand, often exhibit lower tracking errors because they use swaps to directly replicate the index's performance.

Hidden Costs: Despite lower explicit costs, synthetic ETFs can have hidden fees embedded within the swap agreements. These costs aren’t always transparent to the investor, making it harder to fully understand the expense structure compared to traditional ETFs, where costs are more straightforward.

Accessibility to Niche Markets

Synthetic ETFs open the door to markets that would otherwise be challenging or expensive to access. For instance, emerging markets, commodities, and complex strategies that are hard to replicate physically can be more easily tracked using synthetic structures.

Access to Emerging Markets: Traditional ETFs may face restrictions in certain markets due to regulations, currency controls, or trading limits. Synthetic ETFs bypass these hurdles through their derivative structure, offering investors exposure without direct market participation.

Commodities and Alternatives: Synthetic ETFs can also track commodities like gold, oil, or agricultural products without the need to physically store or handle these assets. This feature makes them particularly attractive for investors seeking exposure to commodities without the logistical challenges.

Transparency and Regulatory Concerns

Transparency is a significant point of divergence between synthetic and traditional ETFs. While traditional ETFs provide a clear picture of their holdings, synthetic ETFs’ reliance on swap agreements can make it harder for investors to understand what they’re truly investing in.

Disclosure Differences: Traditional ETFs must disclose their holdings, allowing investors to see exactly which stocks, bonds, or other securities they own. Synthetic ETFs, however, disclose the collateral and swap counterparties but not the underlying components of the swaps. This opacity can be unsettling for investors who value transparency.

Regulatory Scrutiny: Due to the complexity and inherent risks of synthetic ETFs, they have faced increased scrutiny from regulators, particularly in Europe where they are more popular. Regulators have raised concerns about the potential systemic risks associated with synthetic structures, especially in volatile markets.

Performance in Crisis: A Tale of Two ETF Types

The difference between synthetic and traditional ETFs often becomes most apparent during times of market stress. While traditional ETFs’ performance depends on the value of the assets they hold, synthetic ETFs’ performance hinges on the stability and reliability of their swap agreements.

Market Liquidity and Stress Events: In a market downturn, traditional ETFs can suffer from liquidity issues if there is a rush to sell the underlying assets. Synthetic ETFs, however, might avoid some of these issues as they don’t hold the actual securities. Yet, they remain vulnerable to the financial health of their swap counterparties.

Case Study – 2008 Financial Crisis: During the 2008 financial crisis, the weaknesses of synthetic structures were exposed. Some synthetic ETFs faced severe challenges due to counterparty failures, highlighting the risks that can lie beneath the surface. Traditional ETFs, while not immune to market volatility, did not face the same kind of structural collapse.

Choosing Between Synthetic and Traditional ETFs

When deciding between synthetic and traditional ETFs, investors need to consider their risk tolerance, desired exposure, and the importance of transparency. Synthetic ETFs offer access to otherwise inaccessible markets and can be more efficient in tracking benchmarks, but they come with counterparty risk and less transparency.

Risk Tolerance: Investors who are comfortable with the additional counterparty risk and are looking for niche exposures may find synthetic ETFs appealing. However, those who prioritize stability and transparency might prefer traditional ETFs, even if it means dealing with slightly higher costs or tracking errors.

Due Diligence: Given the complexities of synthetic ETFs, it’s crucial for investors to conduct thorough due diligence. Understanding the structure of the swaps, the quality of the collateral, and the financial health of the counterparties is essential before investing.

Investment Horizon: Synthetic ETFs can be particularly useful for short-term tactical plays where the precise tracking of an index is paramount. For long-term investors, the risks associated with synthetic structures may outweigh the benefits.

Conclusion

Synthetic ETFs represent an innovative twist on the traditional ETF model, offering unique benefits such as access to hard-to-reach markets, lower tracking errors, and cost efficiencies. However, these advantages are balanced by risks like counterparty exposure, lack of transparency, and potential hidden costs.

Understanding these differences is key to making informed investment decisions. Whether synthetic or traditional, ETFs continue to evolve, providing investors with a range of tools to meet their financial goals. The choice between them depends on individual risk appetite, investment objectives, and the willingness to delve into the intricacies of their structures.