Synthetic ETFs: the Citywire Selection view

Citywire analyst Frank Talbot gives his view on the concerns raised by the Bank of England over swap-based or synthetic exchange traded funds.

There has been a lot of attention recently on whether all exchange traded funds (ETFs) are appropriate for private investors. In its financial stability report last week the Bank of England was the latest in a line of authorities to highlight the potential for contagion and systemic risk from so-called 'synthetic' ETFs.

As Mike Deverell explained in his column yesterday these ETFs enter into a derivative 'swap' contract with an investment bank, known as a counterparty, to gain the investment return from a particular asset or market. Investors' money is passed to the bank but is not necessarily invested in the relevant assets. Although this can be an efficient arrangement it does mean investors take on the risk of what would happen if the investment bank were to go under.   

Given this I thought I should make Citywire Selection's position clear.

Citywire Selection includes 16 ETFs in markets where we do not feel the options offered by active managers are compelling enough. The list represents three distinct types of ETF, six of which use the swap-based structure. There are also those that use physical replication, and physically backed exchange traded commodities (ETCs). (See below for a full list).

We have been explicit since the beginning of Citywire Selection about our preference for physical replication in equity markets due to the transparency offered. In the case of commodities, it will be those physically backed by the underlying commodity such as gold or silver. However, in some cases the swap-based approach is the only way to gain access to the appropriate index. In Japan for example, we have opted for Lyxor Japan which is the only ETF available to UK investors that tracks the Topix index.

Our primary consideration though has always been the protection of your assets and the legal structure within which the exchange traded product sits. Both physical and swap-based replication ETFs sit within a European framework (Ucits III directive) that secures at least 90% of the assets if the worst should happen.

The rapid development of ETFs has brought with it greater scrutiny, which can only serve to benefit the investors ultimately. Overall, we still believe their flexibility and range make them a viable form of investment for investors looking to track a market quickly and cost effectively.

However, we will continue to be vigilant in monitoring developments in this space.

Physical replication ETFs on Citywire Selection:

iShares S&P 500

iShares FTSE BRIC 50

iShares FTSE/Xinhua China 25