ETFs, synthetic reconciliation and counterparty risk

the issue…

Most ETFs are index-tracking investments.

A key decision for the ETF’s managers is how they will mimic the index while dealing with inflows and outflows of money.

There are two basic choices:

–physical replication, a strategy followed by US-based ETFs: and

–synthetic replication, favored by Europeans.

The fund’s offering documents will spell out what a given ETF intends to, and is allowed to, do.

Physical replication means mimicking the relevant index by buying the constituent elements. In the simplest case, it means buying and selling all the index constituents, in appropriate amounts, as needed. A modified strategy is to use index futures to allow the manager to control the timing of purchase and sales, while still responding immediately to inflows and outflows.

With an index with a lot of members like the S&P 500, it’s also common to find a subset of the index that tracks the overall index with a high degree of accuracy and use it as a substitute for holding the entire index. The ETF can thereby avoid potential problems with trading in illiquid index constituents. Typically, this strategy will be disclosed to investors in the offering documents.  Differences between ETF and index performance that’s attributable to “tracking error” is a risk shouldered by the ETF holder.

Synthetic replication is an extension of the idea that you can use derivatives to supplement holdings of physical securities that are index constituents. In its extreme form, synthetic replication means that the ETF manager negotiates a derivatives deal with an investment bank. The manager agrees to invest the ETF capital in a specified basket of securities and swaps the return on that basket for the return on the ETF’s index.

Synthetic replication has a number of aspects:

–ETF management is simplified substantially, meaning, among other things, that the ETF manager can concentrate on marketing its investment product rather than managing it,

–control of execution of the investment strategy is, in effect, transferred to the investment bank

–the issue of  tracking error can be negotiated away

–the investment bank typically is able to collect income from lending out the securities held by the ETF (presumably influencing the bank’s position about what securities the ETF should hold).

…is always counterparty risk

Synthetic replication also has consequences you should be aware of before buying.

— The swap arrangement negotiated with the bank by the ETF doing synthetic replication is an OTC derivative. This means it’s a contract whose value depends crucially on the financial soundness of the counterparty.

–In the event that the bank is unable to fulfill its obligations to the ETF, shareholders are left with an interest in the securities held in the ETF portfolio. This may, or may not, be the equivalent of the index. In addition, it’s possible that securities lent out to third parties may be involved in litigation and difficult for the ETF to recover and sell.

The risks inherent in synthetic replication are doubtless disclosed in the offering documents.  I’d characterize the risks as having low probability of actually occurring, but potentially having severe negative effects if they do.  The fact that everything is disclosed in the ETF’s official filings suggests that the holder will have no legal recourse against the ETF manager should the counterparty fail.  In selecting this type of ETF, he has taken the risk on himself.

As is the case with leveraged or inverse ETFs, the unwary buyer may only find out about the product’s characteristics when it’s too late to do anything about them.

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