Martin Lee @ Sg
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The Dangers of Synthetic ETFs

Any serious buyer of Exchange Traded Funds (ETF) should know the difference between ETFs that employ a cash-based replication strategy, compared to one that is swap-based (or synthetic replication).

How a swap-based ETF works is that instead of investing into the underlying market, the ETF will hold some other securities and then enter into a swap agreement whereby another party agrees to deliver the index returns to the ETF in exchange for the returns of the underlying securities that the ETF is holding.

In this way, investors of the ETF will be ensured of a return that has very little tracking error of the actual index returns.

The disadvantage of a swap-based ETF is that the investor has exposure to the swap counterparty. If the swap counterparty is unable to deliver on its promise, the investor might be stuck with the returns of the securities that the ETF is holding. In some cases, these holdings might have nothing to do with the index it is supposed to track. There might even be significant losses if the securities have dropped in value or are not easily redeemed.

If the swap counterparty goes bust, you can also expect delays in untangling the whole mess.

To make it easier for investors to differentiate between the two types of ETFs, SGX has mandated that all those ETFs that are synthetically replicated have a “X” inside the exchange name.

But this X in the name could be difficult to spot because the X might not be so apparent or might look like part of the counter name.

For example, Lyxor World 10US$X@ was shown as simply LYX MSCI World inside one of the stock trading platform that I’ve checked. (LYX would like like a short form for Lyxor) Similarly for DBXT MSKorea 10US$X@ which was shown as DBX MSCI Korean.

More than 80% of the ETFs listed on SGX are synthetically replicated.

But there are other risks that many investors might not be fully aware of, nor (in my opinion) are they properly compensated for this addition risks that they are exposed to.

More on this in my next post, Counterparty Risks in Synthetic ETFs.

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Leave a Comment:

4 comments
sender says 12 years ago

Synthetic ETFs seem no different from synthetic CDOs . Quite scary; isn’t it.

Would be interesting to see if there is a synthetic Gold ETF where it doesn’t own any physical gold at all. But investors who invest may think they are buying and owning gold.

Reply
    Martin Lee says 12 years ago

    Sender,

    Yes. It is possible that just like CDOs, synthetic ETFs could be one vehicle for institutions to spin off some of their toxic assets as the underlying collaterals.

    Reply
      sender says 12 years ago

      Martin,

      yea. european banks could well be packaging all their toxic investments (including bonds from greece, ireland, portugal, spain, italy, etc) into some kinds of synthetic ETFs. Then, sell it to gullible investors elsewhere as synthetic ETFs.

      Glad you brought this matter to our attention. Time to warn our friends and relatives to steer clear from them. Hope it isn’t another minibonds saga in the brewing. If so, the culprit next time likely is SGX that will be in hot soup.

      Reply
Charles says 12 years ago

Totally agree with you here;
I have been looking keenly at first at the ETF launched in Singapore as a way to invest elsewhere to the tiny island.

But las!, all I have seen are synthetic; and the culprit here has been Deutshe Bank. launching new synthetic products every other week.

I know that SGX is trying to gain volume, but this is not good.

Reply
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