Synthetic vs. Physical – It’s all about risk

Apr 17th, 2012 | By | Category: ETF and Index News

By Bernie Thurston, Head of Delta One Data (

The debate around synthetic vs. physical ETFs keeps being raised. Unfortunately, without an independent ETF industry body, the debate normally descends into, to paraphrase George Orwell, “physical good, synthetic bad”. This is overly simplistic and upon closer investigation it could be claimed that the pigs are already walking upright.

Synthetic ETFs vs. Physical ETFs – It’s all about risk

Synthetic ETFs vs. Physical ETFs – It’s all about risk, says Bernie Thurston, Head of Delta One Data

The question is not “is physical or synthetic safer?” but instead should be “how risky is this particular ETF?”. Replication methods should be taken into account as part of a more holistic approach to assessing potential risks. If proposed regulation is not designed correctly, it could inadvertently push all ETFs out of the retail market before they have had an opportunity to bring benefits over mutual funds.

The regulators seem to have jumped on this bandwagon, highlighting the systemic risks associated with synthetic ETFs. Fortunately ESMA, in its latest consultation paper, seem to have taken a more measured approach. It is not merely trying to bracket providers by their replication method but, more sensibly, by the associated UCITS structure. This recognises the advantages that the synthetic providers have brought to the market, whilst also raising a flag on some of the approaches taken by the physical providers that have so far been overlooked in the debate.

Some of the advantages synthetic providers have brought to the market include lower overall investment costs, reduced tracking error and access to markets which otherwise cannot be invested in physically. At the same time, they have tried to address some of the systemic risks which they may pose through increased transparency and diversification of counterparty risk.

All of the main synthetic providers, Lyxor, DBx and CS ETFs publish the substitute basket that they are holding. The CS ETFs have also taken this to a high level of disclosure ensuring that all the synthetic ETFs consist of “high quality, liquid, blue chip European securities”. ETFX and Source have tried to reduce counterparty risk by ensuring their have credit diversification across a number of participants. In addition, Credit Suisse has set its swaps to reset on a daily basis such that the client is only exposed to the daily movement of the index, despite this clarity and lack of counterparty risk Credit Suisse has recently converted a number of its ETFs from synthetic to physical, primarily it seems in response to the overly simplistic idea of synthetic is bad

All of this is in comparison to the physical ETF practice of lending out the securities without full visibility of the counterparties or the revenue generated. Last year it was disclosed that the iShares FTSE 250 had lent out 92% of its securities on average over the last year. 60% of the revenue obtained by the securities lending practice is retained by the fund and 40% is taken as profit.

Over the last couple of years the synthetic providers, whilst acknowledging the risks associated with their products, have tried to provide significant transparency on their holdings and reduce the counterparty risk inherent in their replication methodology. In comparison, the physical providers have promoted the fact that their products are safe due to the fact they hold the underlying, but this is not always the case. Thus the debate must move beyond the simple focus on replication methodology but must encompass the various aspects of how the providers are exposed to risk and what is being done to alleviate this risk. Until this happens, a lot of the advantages and diversification benefits built into ETFs will be lost to the retail market due to a simplistic and largely irrelevant classification.

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