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ETF Strategy: synthetics firmly back on buy lists

ETF Strategy: synthetics firmly back on buy lists

Synthetic exchange traded products (ETP) have won back favour among investors, posting positive inflows in January and bucking a six-month trend of outflows amid concerns over counterparty risk.

The latest BlackRock industry report reveals synthetic ETPs attracted inflows of $1.8 billion (£1.13 billion) in January this year, contrasting the last six months of last year where swap-based products experienced combined outflows of $11.7 billion. Physically backed ETPs saw inflows of $9.7 billion over the same period.

Interest in swap-based ETPs even surpassed that of physically backed products, which only gathered $1.5 billion through January.

Broader trend towards passives

The uptake of synthetic ETFs may partially reflect a broader trend towards passives, as January flows surged to a new record. BlackRock’s report said concerns about the European economy, coupled with the US outlook for an extended period of low interest rates helped drive the global ETP industry to its best January ever, with $34.1 billion of net inflows.

January usually sees low or negative flows due to the cyclically high flows in the previous month. Although inflows of $15.8 billion in December 2011 were strong, January still exceeded this figure.

But the wall of cash flowing into swap-based ETPs also suggests investors are becoming more comfortable with the use of derivatives.

Some wealth managers have the ability to trade over-the-counter derivatives, such as swaps and futures, and so are less concerned about the swap component within the ETF.

While investment banks tend to issue swap-based ETFs, as it is a natural extension of their business model, this structure is beneficial for tapping certain markets or regions that may be harder to access or less liquid, without incurring too much tracking error.

Providers typically use swaps, for example, to access the emerging markets. iShares, renowned for its physically backed model as opposed to derivative-based, launched its inaugural synthetic ETF range, using the multi-counterparty structure, in 2010. These funds were created in order to efficiently access Russia and India.

Key considerations

Ben Seager-Scott, senior research analyst at Bestinvest, said: ‘When investing in exchange traded products, issues around counterparty risk are key considerations. In general, for large, liquid indices we generally prefer physical replication, such as those offered by iShares, where there tends to be much less counterparty exposure as the physical shares are held by the ETP – although there are implications from securities lending.

‘However, in the case of smaller, less liquid indices, and instruments in general, physical replication ETPs can suffer from higher levels of tracking error as portfolio management processes have a harder time matching fine movements in the index.

‘As a result, it can often be preferable to take synthetic exposure to these markets, which will track the index more closely as the returns are governed by a swap contract.’

In terms of swap-based ETFs, Seager-Scott would suggest investors use ETP providers that will over-collateralise their counterparty exposure.

He said the physically replicated iShares MSCI Emerging Markets USD ETF, for example, had a tracking error of 0.91% over a year, compared with the swap-based db x-trackers MSCI Emerging Markets TR index, which had tracking error of 0.07% over this time.

Over three years, this tracking error was 1.02% and 0.06% respectively.

Other investors and wealth managers still prefer physically replicated products due to counterparty risk issues, despite the potentially higher tracking error.

Adrian Shandley, managing director of Premier Wealth Management, said: ‘I try not to get exposure to swap-based ETFs because I don’t want to expose clients to unseen risks. It’s a bit like an iceberg in that clients see one thing but what lurks beneath the surface is quite another.

‘You can achieve what you need to with physicals, I don’t see why you should need swap-based products. We use physicals for emerging markets; you can say physical is not as efficient and you get pure exposure with synthetics, but if the underlying swap fails, are you willing to have that risk for a bit less tracking error?’

Shandley said he uses the iShares MSCI Emerging Markets ETF, for example, which physically replicates its underlying index.

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