Are exchange-traded funds dangerous? (Part 2 of 4)

February 10, 2012

In the last Economic Pulse, we refuted a well-publicized criticism about the alleged systemic risk posed by physical exchange-traded funds (ETFs) to the overall equity market. This time, we will review the most important criticism about the other main type of exchange-traded funds: synthetic ETFs. 

What are synthetic ETFs?
Synthetic ETFs differ from physical ETFs in that, instead of holding stocks directly, they hold a combination of cash-equivalent investments (also known as the “collateral”) and a total return swap on a stock index. This swap is a derivative contract with a bank (the counterparty) that ensures that the fund will receive exactly the return on the index minus management fees. It is important to note that, while synthetic ETFs are scarce in Canada and the U.S., they make up roughly half of the European ETF marketplace.

What is the concern about synthetic ETFs?
The risk of synthetic ETFs is threefold:

  1. The volatility risk, which is common to physical ETFs, synthetic ETFs and mutual funds;
  2. The counterparty risk of the total return swap;
  3. The credit risk of the collateral.

A frequently heard criticism is that synthetic ETFs introduce the threat of a large unexpected loss if the counterparty defaults. In other words, the bank that signed the swap agreement with the ETF manager could, if financially distressed, fail to deliver the index’s return, which would result in a large loss for investors.
Another criticism is that if ever the cash-equivalent investments held by the ETF defaulted, then ETF investors could lose big.

Are these concerns warranted?
It is true that synthetic ETFs carry a significant counterparty risk; however, this risk is limited in scope. Total-return swaps involve only an exchange of the returns on their underlying indices (namely, a stock index against a short-term interest-rate index) at a pre-determined frequency. In Canada, regulations require that counterparty risk not exceed 10% of the value of a fund; therefore, Canadian synthetic ETFs settle the amount of accumulated profits on the total-return swap whenever the amount at risk approaches this 10% limit.

It is also true that a credit default on poor-quality collateral could result in a large loss. It is therefore very important to read the prospectus of a synthetic ETF before investing, to ensure that a proper investment policy is in place to protect investors against the credit risk to the collateral.

Synthetic ETFs carry additional risks that are not present in funds that hold physical securities. But these risks can be greatly mitigated. The counterparty risk can be reduced chiefly by holding total-return swaps with multiple banks for the sake of diversification. The credit risk on the collateral can also be substantially reduced by holding federal government securities or investments that carry an explicit or implicit guarantee from the government. It is also noteworthy that synthetic ETFs offer some advantages over comparable physical ETFs: they are more tax-efficient; their management fees are lower; and, they track their index more closely in most cases. In a nutshell, we don’t believe synthetic ETFs should be summarily dismissed as “bad investments”; each security should be analyzed and judged on its own merits. To date, PWL has chosen not to include them in portfolios because we are not convinced that the products currently available in Canada offer advantages that outweigh their drawbacks. But we will remain at the forefront of ETF research going forward, looking for new investment solutions to build better portfolios.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.