Synthetic ETFs becoming increasing popular in recent days. In the world of ETFs, it is the next hot ETF like Tesla in the stock market. It is seen as superior product compared to physical ETFs.
It is an innovation in financial engineering which provide some benefits to the investors. But not without specific risks. The investors should be aware of the risk before decide to include in a portfolio.
How Synthetic ETFs works
Synthetic ETFs deliver the returns of an index like physical EFTs but in an unconventional way.
Unlike, physical ETFs, synthetic ETFs do not directly own the assets in the index. Rather, it uses derivatives to deliver the returns of the index. These derivatives includes swap. It is otherwise called swap-based ETFs.
As a result, the synthetic ETFs can deliver the returns of an index without actually owning it. This can lead to low tracking error as opposed to physical ETFs.
The Structure of Swap based ETFs
The swap-based ETFs have below structures.
- Unfunded Structure
- Funded Structure
Under Unfunded Structure
- The Fund (Synthetic ETF) buy and hold baskets of securities (assets)
- The fund uses the returns from assets to pay out the swap counterparty
- In return, the counterparty pays the returns from the index to the fund.
Under Funded Structure
- The fund pays the cash from investors to swap counterparty
- In return, swap counterparty pays returns from the index to the fund (ETF)
- Swap counterparty post collateral to a custodian and it is pledged to the fund
- The collateral is hold by an independent custodian and not by the fund (ETF)
- In case, if the counterparty defaults, the collateral maybe provided to the fund (ETF).
Below are the benefits of synthetic ETFs.
- Low tracking error
- Low expense ratio
- Dividends may not be withhold taxed under exemptions.
Generally, both physical and synthetic ETFs subject to withhold tax on dividends. This means the ETF provider has to pay 30% (if domiciled in United States) or 15% (if domiciled in Ireland or UK) on the dividends. The dividends are passed on to investors after withhold tax.
However, there are some exemption for the tax treatments on derivatives and some synthetic ETFs meet the criteria for the exemption avoids withhold tax. For example, the new iShares Synthetic ETFs (ticker: I500) do not pay withhold tax on dividends.
As a result, this can boost the performance of the index higher than a physical ETFS that track the same index. Blackrock says it can boost performance by 0.3%.
Risks with Synthetic ETFs
Since the Synthetic ETFs involves buying derivatives, the counterparty risk here is real. This is most concern risk to the investors. Because, swap based ETFs rely on derivatives involves credit risk and worrying concern of default.
In a case, where an institutions hold various roles such as index provider and swap counterparty. It involves the risk of conflict of interest. In the event of the market crisis, the investors would be one gets affected as the collateral is owned by the same institutions which provides the fund (ETF).
If the counterparty is defaulted, there is a risk collateral’s value may deteriorate. Also, the bankruptcy administration can freeze the collateral if it is pledged and the counterparty fails. Under European regulation, the counterparty exposure is limited to no more than 10%. However, the collateral risk is imminent as the collateral value may not be enough to cover the fund.
Synthetic ETFs may provide a slight boost to the performance as opposed to physical ETFs. However, it achieves with a complex financial derivatives. These derivates carries specific risk. And the complexity involved with synthetic ETFs are hard for a retail investors to understand and digest.
Unless, you understand it and comfortable with such a complex structure, it is not wise to invest in these investment vehicles.