The suggestion from HSBC for providers of swap-based Exchange Traded Funds (ETFs) to use the letter x to identify the use of derivatives makes real sense.
This requirement was introduced last year in Hong Kong by the Securities and Futures Commission.
Like the FSA, we have concerns that synthetic ETFs are unlikely to be suitable for retail investors.
With the counterparty and collateral risks they introduce to the investment process, most investors would be well advised to shun synthetic ETFs and instead stick to those funds using full physical replication.
Different ETFs use different strategies to replicate the return of their chosen index or asset class.
Physical replication is the easiest strategy to understand.
Where an ETF uses ‘full replication’, it is simply buying all of the underlying stocks within the index it aims to cover, in the right proportions. All the ETF manager then needs to do is ensure the ETF holdings continue to represent the index.
Synthetic replication is a strategy that aims to achieve a fund performance closer to the actual performance of the index.
Instead of holding every stock in the index, an ETF manager following a synthetic replication strategy instead short circuits this stock ownership with a derivative contract agreed with a counterparty.
The counterparty pays the ETF provider the index return in exchange for a flow of cash. They put up collateral against this derivative contract in case things go wrong.
If the counterparty goes bust then the ETF provider must rely on the collateral to provide the ETF return to investors.
Where the collateral turns out to be illiquid stocks unwanted in other parts of the business, this can result in the synthetic ETF investor getting back far less than they expected to receive.
When selecting an ETF, it is important to understand the methods used by your chosen ETF provider.
Photo credit: Flickr/ashi
