Exchange-traded funds, or ETFs, are a relatively young investment vehicle, but have become incredibly popular for good reason. These funds give investors diversified access to the entire market, or sectors within it, at a low cost.
Any time a product or service is popular, new versions seem to pop up over time. One spin-off of the traditional ETF offered by various financial institutions around the world is known as the synthetic ETF.
Like a synthetic oil blend, synthetic ETFs are similar to their traditional counterparts but are not made up of the same materials.
What Is a Synthetic ETF?
Synthetic ETFs are a relatively new investment vehicle, first created in 2001, that are similar to traditional ETFs, mutual funds, and index funds in that they are pooled investments. This means the provider of the fund raises money from a large group of investors. That money is compiled and invested for shareholders as outlined in the fund’s prospectus.
However, there’s one major difference between synthetic and traditional funds. Traditional funds attempt to create returns by purchasing a diversified portfolio of equities, generally common stock. Synthetic ETFs are the synthetic replication of this process.
Popularized in Europe and Asia, synthetic funds use derivatives and swaps in an effort to match the returns of the benchmark they track. The fund and its investors never actually own a single share of the stock.
Instead, the ETF provider enters into swap contracts with a swap counterparty, usually an investment bank. Under the swap agreement, the counterparty is required to provide returns equal to that of the benchmark index the fund was designed to track.
Why Do Synthetic Funds Exist?
Synthetic funds offer a realistic way to invest in assets that are otherwise difficult to add to your portfolio, like remote reach markets — markets with technological and geographical barriers to investing — and relatively illiquid benchmarks that would be difficult and expensive for traditional ETFs to invest in.
Also, many argue that synthetic ETFs do a better job of providing returns proportional to the underlying benchmark of the fund.
For example, when a traditional fund tracks the S&P 500, it invests in every stock listed on the S&P 500 and tries to equally match the index’s allocation to each stock. However, there are always going to be small differences in allocation, which could lead to a deviation from the returns of the S&P.
With synthetic ETFs, an investment bank is under contract to provide the exact returns experienced by the underlying benchmark. Whether or not the investment bank’s own investments have achieved that goal, the counterparty agreement requires it to pony up the expected returns.
Limited Options in the United States
There are only a handful of asset managers that offer synthetic ETFs in the United States, and the reason has nothing to do with the investment vehicle being new. In 2010, the U.S. Securities and Exchange Commission (SEC) set regulations that prohibited the launch of new synthetic funds by asset managers that didn’t already sponsor one.
The regulation was created out of an abundance of caution based on the SEC’s belief that the average investor didn’t quite understand what synthetic funds are and their risks. In particular, the SEC pointed out that counterparty risk, or the risk that the counterparty will fail to pay the agreed-upon rate of return, is higher than most investors perceive it to be.
While the regulatory environment in the U.S. means that there aren’t many domestic synthetic funds to choose from, they remain popular options in Europe and Asia.
By setting regulations that limit new asset managers from launching synthetic ETFs, the SEC achieves three goals:
- Limiting Options. Limiting the number of synthetic funds on the market, meaning that the general investor is less likely to invest in them.
- Maintaining Oversight. Limiting the number of asset managers that can launch synthetic ETFs, making regulatory oversight more manageable.
- Keeping Options Open. Maintaining some limited investment options that allow investors low-cost access to otherwise hard-to-access assets.
Types of Synthetic ETFs
There are two main types of assets in this asset class: funded and unfunded synthetic funds. Here’s how they differ:
The Unfunded Swap Model
The unfunded swap model is the most common. In this model, the fund pools investment dollars from a group of investors that are used to purchase baskets of assets from the swap counterparty.
As part of the swap agreement, the assets purchased are then held by the fund issuer as collateral. If the investment bank fails to pay the return as stated in the agreement, the basket of assets becomes the property of the ETF and may be liquidated to return value to investors.
It’s important to remember that the basket of assets held as collateral isn’t required to even be in the same asset class as the underlying benchmark represented by the fund. So, should the collateral require liquidation, the return to the investor has the potential to be significantly different from expectations.
The Funded Swap Model
The funded swap model is similar to the unfunded swap, with one key difference. Instead of the issuer of the fund holding onto the collateral under the swap agreement, the collateral is placed in a collateral basket in a separate account rather than held by the ETF.
From there, the counterparty hires an independent custodian to manage the collateral basket and ensure it is being used for its intended purposes while being held as collateral.
Synthetic ETFs vs. Physical ETFs
Now that you know what synthetic ETFs are, it’s easy to point out the key differences between them and their traditional counterparts. Here are the main differences:
According to Scientific Research, synthetic ETFs come with higher average expense ratios. For example, emerging markets synthetic funds have an average expense ratio of 0.69%.
Traditional ETFs that track broad swathes of the market are widely accepted as a relatively low-risk, diversified investment model. All ETFs carry some risk, and those that track riskier assets may be more at risk of losing money from falling asset prices.
Synthetic funds carry all the same market risks as traditional ETFs, but with the added risk due to the involvement of a counterparty, rather than owning the underlying asset.
Types of Benchmarks Covered
Traditional ETFs cover a wide range of benchmarks, from broad-market indexes to industry specific benchmarks that track tech, energy, health care, or other sectors.
Synthetic ETFs generally track benchmarks either centered around hard-to-access assets or created to track the returns of complex, expensive trading strategies.
Pros and Cons of Synthetic ETFs
As with any other form of investment, there are benefits and drawbacks to a synthetic fund. Some of the most important include:
Pros of Synthetic ETFs
There are plenty of reasons to consider investing in synthetic funds. These funds provide widespread access to emerging markets, less chance of tracking errors, and simplified investing. Here’s why investors like synthetic funds:
- Access to Assets. Many indexes in emerging markets around the world are hard to tap into due to a lack of financial infrastructure. These funds allow ETFs to execute trades to track investments that would otherwise be too costly to consider.
- Accurate Expectations. Because the counterparty is bound by contract to provide specific returns, these funds often provide investors with more accurate expectations. If a synthetic fund says it tracks the S&P 500, chances are it does so with little margin of error.
- Collateral. Any investment you make involves risk. Although synthetic funds don’t invest in stocks directly, they do hold collateral, helping to mitigate risks should the counterparty fail to pay as agreed.
Cons of Synthetic ETFs
Sure, there are plenty of reasons to consider buying into a synthetic fund. However, there’s always a skeleton or two in the closet, and these funds are no different. Here are the drawbacks ETF investors should consider before going the synthetic ETF route.
- Counterparty Risk. For the synthetic fund to work, both the issuer and the counterparty need to live up to the words in their agreement. If the counterparty fails to pay as agreed, the ETF and its investors could experience significant losses.
- Liquidity Risk. Synthetic funds aren’t the most popular funds on the market, and when you decide it’s time to exit your position, there’s no guarantee that someone will be ready and willing to buy your shares. As a result, you may be left holding your investment longer than originally intended.
- Collateral Risk. The collateral for these funds can be any financial asset, not necessarily the assets included in the underlying index for the fund. As a result, the collateral may be vastly different, resulting in a far different return than expected if the counterparty defaults.
- Conflicts of Interest. Issuers of synthetic ETFs act on behalf of the investors when negotiating with the investment bank. However, in many cases, the fund issuer is a subsidiary of the investment bank. This creates a conflict of interest when the synthetic fund provider acts as an intermediary between its parent company and its client.
At first glance, synthetic ETFs seem like a great investment opportunity. After all, who wouldn’t want to invest knowing that their returns will be equal to the benchmark they plan on tracking? The problem is that investments don’t always go as planned, and with synthetic funds, when they go wrong, the results are often incredibly painful to your portfolio.
Nonetheless, there are reasons many consider investing in these unorthodox funds, including access to assets for which there are no traditional ETFs.
If that’s the route you choose to go, keep in mind that research provides a solid foundation for all investment decisions. Learn everything you can about the fund you’re considering before risking your hard-earned money.