The Sweet, Short Life of Synthetic ETFs
January 20, 2012
You’ve heard of structured products. These largely were (and are) complex securities based on lots of streams of cash in underlying loans whose flows were not well predicted. There was a credit crisis associated with them in 2008.
Now come “synthetic” exchange-traded funds, where interest-rate swaps and other derivative products are used to replicate the performance of a securities index.
Only synthetic ETFs are likely to disappear almost as fast as they arrived. The European Securities and Markets Authority this year is expected to introduce new rules that get tougher on the collateral required for synthetic ETFs. That will, according to researcher Celent, make them “costlier and less attractive to asset managers and investors alike.”
That may not matter much in the United States. While this country is by far the largest market for exchange-traded funds, investment pools here are more interested in so-called “physical” ETFs. In such funds, there is investment in actual physical products such as stocks, bonds or commodities.
Synthetic ETFS have not made much of a dent here, amounting to about 3% of the market in the United States. They have not fared much better in Asia, where they account for 11% of assets placed in ETFs.
But in Europe, they’ve been hugely popular. By Celent’s calculations, their share of the overall European ETF market rose from around 21% in 2005 to more than 45% of the value of funds in 2011.
The asset managers that run synthetic ETFs are often affiliated with leading banks, says Celent Senior Analyst Anshuman Jaswal.
Being part of the same group offers them access to securities that would otherwise sit idle with their affiliated bank. These securities are used as collateral by the ETF managers, which helps them to save on collateral management costs. That makes the synthetic ETFs cheaper than their physical-products-based brethren.
Thus, says Jaswal, “the synthetic ETFs are cheaper.”
The overall volume of trading in synthetic ETFs has declined since 2007—the year before the subprime mortgage market imploded and the market in securities based on the cash flows from mortgages went with it.
But Europe has remained at the forefront of producing synthetic ETFs. Of all issuance in the world, Europe accounted for 87% in 2010. The U.S. share? 6%. The rest of the world? 7%.
Indeed, in 2010, about a billion dollars moe went into synthetic exchange-traded funds, than their physical brethren, in Europe.
But the European love of synthetic ETFs appears to be ending, however. A greater regulatory scrutiny of synthetic exchange-traded products has led to declines in their volume of issuance and trading.
European exchange-traded funds and products had net new inflows of $28.1 billion in the first 10 months of 2011, according to Celent. Of that, physical exchange-traded products attracted the majority of inflows in Europe, at $26.8 billion, by Celent’s count. Meanwhile, synthetic ETPs pulled in $1.25 billion in new flows.
“This was a big change from 2010 when synthetic instruments managed to attract more inflows than physical ETFs,’’ Jaswal said, in a report prepared for Celent and published at the turn of the year.
Regulations in the United States are stricter, he says. Europe’s rules, under its Undertakings for Collective Investment in Transferable Securities initiative are more flexible.
