Avoid synthetic ETFs

There are two types of ETFs - physical and synthetic ETFs. Physical ETFs are invested in the underlying shares. Synthetic ETFs are invested in derivatives to mimic the index returns. 

Investors should avoid the synthetic ETFs. Some issuers take the cash and replace them with illquid, hard to value products as collaterals. If the investors rush to liquidate their positions, the issuers might not be able to raise enough cash to pay off the investors. The synthetic ETFs also face the counter party risk where the other party to the derivatives may not be able to honour their obligation.

The Straits Times Index ETFs marketed by SPDR and DBS are physical ETFs - which do not have the risk of the synthetic ETFs.

Read this article.

First it was CDOs, then SPVs. Now the latest alphabet soup of financial products to come under scrutiny from regulators as potential threats to investor protection and economic stability are ETFs and ETPs – exchange traded funds and similar products.
  Securities regulators in the US and EU are worried that these increasingly complex products are being mis-sold to unwary investors who do not understand the counterparty and derivatives risks they are running.
  Prudential regulators meanwhile are concerned that banks, particularly in Europe, are using ETFs as a cheap source of funding and are stuffing them full of illiquid collateral. They worry about the potential for a serious run – akin to the 2008 breaking of the buck in money market funds – if investors all head for the exits at once.
  Originally conceived as a low-cost way to track stock indices, ETFs got their start in 1989 as baskets of securities that could be bought and sold throughout the day. But the structure has rapidly expanded into everything from currencies and commodities to bonds and mortgages. There are now nearly 4,000 exchange traded funds, notes and   commodities, known collectively as exchange traded products, with total assets under management of $1,626bn as of mid-year.
  To make matters even more confusing, many of the funds are now “synthetic”, relying on derivatives to deliver promised returns rather than holding the actual basket of goods as “physical” ETFs do. And despite the name, many exchange traded products change hands over the counter rather than on an exchange.
  Concern has been rising, since US regulators first warned investors in 2009 that some synthetic ETFs, particularly those that promised a multiple or the inverse of a particular   index, were failing to deliver that result over the long term.
  Global regulators raised the stakes in April, when the Financial Stability Board, a closely watched group of regulators and central bankers, made ETFs the subject of its first big warning about new sources of systemic risk.
  The debate reached a fever pitch last month, when UBS announced that a relatively junior employee had racked up a $2.3bn loss in unauthorised trading involving these and other instruments. While UBS’s woes may well have more to do with compliance and risk control than ETFs per   se, the scandal has fuelled regulators’ fears that the products could be the next financial instruments to turn toxic.
  Last week, Steven Maijoor, chairman of the new pan-EU regulator Esma, the European Securities and Markets Authority, reiterated that existing rules governing ETFs were “not sufficient” and tougher action now appears inevitable.
  The investor protection concerns have focused mainly on “synthetic” ETFs for three separate reasons: do investors understand them, do they deliver the promised returns and what are they taking as collateral – the assets posted as security in case the derivative provider goes bust.
  Systemic regulators, including the FSB and the new European Systemic Risk Board, are also worried about the collateral issue for a different reason.
  They think that banks may be using the cash the ETFs bring in to fund themselves, while giving the ETFs risky and hard to price securities as collateral. That takes the securities off the books of the bank – where they would carry high capital charges – but could create liquidity risk if lots of ETF customers want their money back at once.
  To some, the arrangement also seems eerily reminiscent of the off-balance-sheet special purpose vehicles and collateralised debt obligations that got so many banks in trouble in 2008.
  Mervyn King, governor of the Bank of England, said recently that regulators needed to investigate “whether certain aspects of this use of the funds invested in ETFs are being   directed towards opaque and complex funding structures”.
  US regulators have put a moratorium on approving any new ETFs that use derivatives while a review is conducted. Hong Kong’s regulators recently set tougher new standards for synthetic ETFs, requiring them to post collateral worth at least 100 per cent of the ETF’s assets to minimise counterparty risk.   Synthetic ETFs also have to be clearly labelled, with an X in front of the name in listings.
  In Europe, Esma is consulting on whether there should be restrictions of the sale of “synthetic” ETFs to retail investors and it also wants much clearer disclosures on collateral practices.
  BlackRock, which owns iShares the world’s biggest ETF provider, said on Tuesday   that it would be pushing for tighter controls on collateral and disclosure to investors in an effort to protect the industry’s reputation.
  “We are hoping that there are regulatory standards set for the type of collateral and the haircuts required . . . If you have a fixed-income product, why would it be collateralised with Japanese equities?” says Joseph Linhares, managing   director at iShares.
  Other fund managers disagree. Efama, the representative association for the European investment management industry, argues that there is no need for new ETF-specific regulation and synthetic ETF providers that their products have been unfairly targeted.
  But the renewed focus by regulators suggests that the battle against tighter rules may have already been lost. FT