Investors who invest using the increasingly popular ETFs have probably come across the term “synthetic ETF”. But what is that anyway?
• Synthetic ETF: Index replication using swap transactions
• Lower tracking error thanks to exact index replication
• Synthetically replicating ETFs are often difficult to understand
Exchange Traded Funds (ETFs), i.e. funds traded on an exchange, are increasingly becoming the focus of European investors. These assets can be divided into two main categories – physical and synthetic. Physical ETFs are quite easy to understand because they simply replicate the performance of an index (e.g. DAX or SMI) by actually purchasing the assets that they are intended to reflect – for example the stocks contained in the corresponding index. Since equal weighting is taken into account, the value of the ETF falls or rises together with the price of the stock index.
Synthetic ETFs
Synthetic ETFs also mimic the results of an index, but without directly purchasing the stocks included in the index. Instead, ETF issuers enter into swap agreements – that is, an exchange transaction – with a third party, such as a bank. The swap ETF then receives the performance of the tracked index from the exchange partner, who is often also the issuer of the ETF, and in return gives it the performance of the securities contained in the swap ETF. This is also referred to as artificial, “synthetic replication” or “indirect replication”.
Synthetic replication is often used when the index being replicated includes a large number of stocks, such as the MSCI World with its over 1,500 positions. Constantly adapting an ETF to an index with such a confusing number of securities is complex and cost-intensive.
Advantages of Swap ETFs
Some asset classes are only made investable through indirect replication. An example of this are money market ETFs, which are difficult to reproduce without synthetic replication. Another example is commodity ETFs because futures are traded here. Thanks to synthetic ETFs, investors are also able to invest in niche indices that only have a low trading volume or where access to the assets via the stock exchanges is rather difficult, for example in stock markets that are closed to foreign investors.
One of the most important advantages of synthetic ETFs is that they only have a very low tracking error, which means they can replicate an index very precisely. They owe this accuracy to the fact that they usually have lower costs than physical ETFs. In general, the costs for investors with synthetic ETFs are usually somewhat lower than with physical ETFs. This is due to the fact that the former primarily incur costs when concluding swap contracts, whereas the latter incur transaction costs when constantly buying and selling securities.
Disadvantages of synthetic replication
On the other hand, these advantages also come at a price, because investors take on so-called counterparty risk – also known as counterparty risk. Not only do you run the risk that the actual assets – e.g. the shares in the index being tracked – will lose value, but you also have to worry that the swap partner will have payment difficulties or become insolvent. So even though the ETF is entitled to the appreciation of the underlying index under the agreement, it doesn’t always get it if the other party can’t pay.
However, in order to limit this risk for investors, the EU has issued regulatory provisions: For example, the amount of exchange transactions is limited and collateral must be maintained, which is then adjusted regularly.
It should also be noted that replication may be less straightforward with swap ETFs. Then synthetic ETFs – in contrast to physical ETFs – are less easy to understand for the investor.
Editorial team finanzen.net