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 [email protected] 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 [email protected] 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.