Investors remain wary of ‘synthetic’ ETFs

Nov 22nd, 2011 | By | Category: Equities

A survey conducted by fund research group Morningstar has shown that despite ongoing efforts by providers of swap-based ETFs to improve transparency and investor protection, investors remain wary of ‘synthetic’ ETFs.

Investors remain wary of ‘synthetic’ ETFs

Investors remain wary of ‘synthetic’ ETFs

According to the survey, investors are becoming increasingly concerned about counterparty risk, with 90% of respondents “somewhat” or “very” concerned.

Of those surveyed, 90% also stated a specific preference for physically-replicated funds over synthetic swap-based funds.

These findings follow a series of warnings about exchange-traded products from global regulators in which ‘synthetic’ ETFs, in particular, have come under scrutiny.

This type of ETF delivers the performance of the underlying index, not by holding the underlying index constituent securities, but by entering into a swap agreement with a counterparty to receive the performance of the index.

This counterparty is usually an investment bank and often parent to the ETF provider itself, raising concerns about counterparty risk and conflicts of interest. Moreover, the collateral guaranteeing the swap may bear no resemblance to the underlying securities, prompting many to question the suitability of such structures in the event of a default by the swap counterparty.

Swap-based ETFs do offer many benefits, most notably reduced tracking error (especially in illiquid emerging markets) and lower costs, and can be more appropriate in certain circumstances. Furthermore, in many swap agreements the collateral underpinning the swap exceeds the exposure to the counterparty (so-called over-collateralisation). However, these advantages seem not to have offset investors’ concerns.

“Common across all respondents is a growing and very strong preference for physical replication ETFs over their synthetic alternatives,” said Morningstar director of European ETF research Ben Johnson, talking to IFA Online.

“No doubt spurred on by the flurry of warnings from global regulators earlier this year, nine out of ten investors are now “somewhat” or “very concerned” about synthetic ETFs.”

Meanwhile, the survey also pointed to the need for further education among private and professional investors alike.

Sixty-five percent of private investors stated that they would like to learn more about ETFs before investing, while 64% of professionals cited a desire to learn more before deploying them in their own or their clients’ portfolios.

But while there are concerns and a need for further education, the appeal of ETFs remains clear to both current and prospective investors alike. In particular, their low cost structure continues to resonate with investors, with 91% of current ETF investors and 93% of prospective users citing ETFs’ low costs as being either a “very important” or “important” attribute.

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