ETFs were once the holy grail for investors: index returns at minimal cost. And in almost all respects, they still are. But the proliferation of new asset classes and new ways to get access to hitherto inaccessible asset classes, such as commodities or short-selling strategies or bullion, has eventuated in ETF structures – frequently denominated as “synthetic structures” — that many fear put investors are much greater risk then they were prepared to take on.
Certainly the debate is not new. Even global regulators – not normally the quickest beasts on the planet — have taken notice, including the International Monetary Fund, the Financial Stability Board and the Bank for International Settlements. But Morningstar offers a comprehensive addition to the debate, in a recent report called “Synthetic ETFs Under the Microscope: A Global Study.” Morningstar thinks synthetic ETFs – which engage in forward contracts and total return swaps with investment banks – have taken a bad rap, not least because, while synthetic ETFs do indeed incur counterparty risk, so do many plain-vanilla ETFs, through their securities-lending programs.
So what to make of these new ETFs? “[C]ertain key themes ring true around the globe,” Morningstar says. “In all geographies we studied, the topics of transparency and security are top-of-mind for investors, providers, and regulators alike.”
And for good reason. “Synthetic structures contain some unique sources of risk. In assessing the risks associated with these structures it is important to address three key questions:
1 What is the source of the risk?
2 How are investors being protected against this risk?
3 How are investors being compensated for assuming this risk?”
That’s true of any new investment product that goes beyond a traditional stock and bond portfolio. Although many of these products are intended to mitigate risk, they have the unfortunate propensity of revealing new risks.
In this instance, with synthetic ETFs – funds that don’t hold the underlying investments directly, but instead enter into swap agreements – there is a new frontier. You never know whether your counterparty on the swap will be this year’s Lehman Brothers – and whether its collateral will be worth more than a plugged nickel once all the creditor claims have been settled.
That fear may be overblown. There are two ways to do a swap. In the unfunded arrangement, the ETF directly owns a basket of securities as collateral. Generally the account is 90% collateralized, leaving, on a daily basis, a 10% exposure to a counterparty. In a funded arrangement, the ETF’s collateral is held in a segregated account at a third-party custodian. Generally, the segregated account is overcollateralized. Increasingly in Europe, funded ETF’s – which only started in 2009 — are shifting to an unfunded but fully collateralized arrangement because it’s both cheaper and gives the appearance of being more liquid.
Hence, Morningstar argues, “We think there is still room for improvement as it pertains to the frequency and quality of public disclosure of the composition of collateral and substitute baskets. We would expect providers to give regular and full disclosure of the identity of swap counterparties as well as the amount of counterparty exposure on a fund by fund basis.”
Fair enough. But this sort of disclosure is probably not going to sit happily with Wall Street banks who have just seen their own hedging strategies gone awry – think JPMorgan Chase. Oddly, the Morningstar paper does not analyze the U.S. ETF market.
Still, there has been progress in Europe, thanks in part to the debate. “[A]ll synthetic issuers (bar one) now publish the composition of substitute/collateral baskets on their websites. Whether these measures have been taken as a form of self-defence or represent a demonstration of goodwill, the end result of increased transparency ultimately benefits all stakeholders. It is also worth noting that similar measures have not been taken by virtually all those providers of physical replication ETFs that engage in securities lending”.
Just as important, however, Morningstar says. “Providers of swap-based ETFs have generally not been forthcoming with details on the swap costs embedded within their products, and this remains an area needing improvement.”
That said, when it comes to default risk Morningstar concludes, “Each of these funds has built-in protections against counterparty default. First and foremost, a large majority of synthetic ETFs worldwide are subject to regulation that limits the amount of counterparty exposure they can have to any single issuer via a derivative. In practice … most providers hold assets or collateral in amounts that are either near, equal to, or greater than their fund’s net asset values. Some providers engage multiple counterparties in order to diversify their funds’ exposure. These are just a handful of the most important safeguards that have been put in place to protect investors in synthetic ETFs from counterparty risk. Lastly, it is important that investors are compensated for assuming this additional form of risk. In general, synthetic ETFs have shown that they offer some compensation in the form of lower total holding costs. Holding costs represent a combination of the ETF’s total expense ratio (TER) and tracking performance against their benchmark. Generally speaking, synthetic ETFs have proven to have lower TERs (with some Asian ETFs being notable exceptions) and superior tracking relative to physical products.”
That is, in the end, the key question. Investors may make better returns with synthetic products –through substantial cost savings. But there is a cost. In other words, there is no free lunch. But at least the prices – and standard deviations – should be disclosed upfront.