While some investors may be wary of the risks associated with synthetic exchange-traded funds (ETFs), these ETFs can be a highly valuable tool for investors, says Morningstar’s director of ETF and closed-end fund research, Scott Burns.
In particular, synthetic ETFs are generally more effective at tracking their respective indices and tend to have lower tracking errors compared to their counterparts: physically-replicated ETFs. Synthetic ETFs also generally have much lower total expense ratios (TERs), with some ETFs even boasting 0% TERs in Europe.
However, concerns about counterparty risk tend to hold investors back from considering synthetic ETFs, says Burns. Investors not only have to think about investment risk (whether the ETF will go up or down in value), they also have to worry about counterparty risk. But this counterparty risk is generally blown out of proportion, says Burns. This same kind of counterparty risk exists in many other kinds of funds for individual investors, but it’s simply not discussed as much, he says.
“This isn’t systemic risk, no more than what is out there in other investments, in particular structured products,” he said. “Using a broader comparison of what is out there for investors, a synthetic ETF is more liquid, more collateralised and more transparent than other structured products.”
The conclusion? Synthetic ETFs can be a very effective, very low cost, index tracking tool, but investors must simply be sure to complete their due diligence before making an investment. Investors must understand the risks before taking the plunge. They may realise that taking on counterparty risk results in a better return, which balances the risk-return trade-off, says Burns.
Burns was speaking at the sixth annual Morningstar Investment Conference in London.
For more information about synthetic ETFs, read "Synthetic ETFs Under the Microscope: A Global Study".
Executive Summary of the Report
- In this updated and expanded report, we build upon our original examination of synthetic exchange-traded funds (ETFs) in Europe, highlighting recent progress made by providers towards increasing the degree of investor protection within their products and the level of transparency around them.
- ETFs are a global product category and we have widened our field of study accordingly. We have included a detailed examination of synthetic ETFs in Asia, Canada, and Australia.
- The structural details of synthetic ETFs and the local regulations that they are subject to vary quite widely across geographies.
- However, certain key themes ring true around the globe. In all geographies we studied, the topics of transparency and security are top-of-mind for investors, providers, and regulators alike.
- Synthetic structures contain some unique sources of risk. In assessing the risks associated with these structures it is important to address three key questions:
- What is the source of the risk?
- How are investors being protected against this risk?
- How are investors being compensated for assuming this risk?
- Perhaps the most significant development we have seen in this space over the last twelve months has been the evolution of practices with respect to counterparty risk mitigation.
- We have also seen major improvements in the area of transparency.
- However, there are a number of lingering issues that we feel the industry needs to address.
Alanna Petroff is a financial journalist with Morningstar.co.uk
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