About the physical and the synthetic in ETFs

Physical vs synthetic replication

ETFs are investment funds that replicate the performance of a certain benchmark index. There are two ways in which an ETF can achieve its objective of replicating the return of the benchmark:

  1. Physical replication; when the ETF fund owns all or a sample of the securities that compose the index.
  2. Synthetic replication; when the ETF fund enters into a total return swap transaction with a counterparty (usually an investment bank) that agrees to pay the return on the index.

 The main difference between these two forms of replication is that the synthetic one involves some counterparty credit risk.  Since it is the swap counterparty that guarantees the payment of the index return to the ETF, should this counterparty go bust during the life of the contract then the ETF investors could have some problems in recovering their investment.

On the other end, synthetic ETF have some advantages over physical ones that compensate for the increased counterparty risk:

  1. They allow to replicate also illiquid or difficult to access markets
  2. They usually have lower total expense ratios (TER) than physical ETF
  3. They show a lower tracking error than physical ETF

Swap structures

The swap behind the synthetic ETF can take two forms:

  • Unfunded swap model – the ETF fund uses the cash received by the investors to buy a basket of securities (the “substitute basket”) from the swap counterparty and agrees to pay the return generated by this basket of securities to the counterparty against receiving the return on the index to be replicated. The substitute basket usually does not include the constituents of the ETF benchmark index but in some cases may be highly correlated to them.
  • Funded swap model – the ETF fund delivers the cash received by the investors to the swap counterparty that agrees to pay the performance on the index to be replicated plus the nominal at a future date. The swap counterparty also posts a collateral basket (in the form of equities, bonds or cash) in a segregated account with an independent custodian. If the counterparty defaults, the collateral can be liquidated and the proceeds used to recover investors’ money.

How to invest: counterparts risk mitigation strategies

In order to mitigate the counterparty risk the ETF fund generally enters into swap contracts that “reset” once the exposure to the counterparty has reached a certain limit. According to European UCITS rules the fund exposure to the counterparty should not exceed 10% of the fund’s net asset value but ETFs often use stricter resetting rules. On reset dates, if the value of the swap payments to be received by the ETF fund has increased, the swap counterparty will be required to post additional collateral.

Often, as a further safeguard, the ETF fund may require some form of over-collateralisation. In this case the value of the collateral posted by the counterparty will exceed the net asset value (NAV) of the ETF. Of course not only the quantity of collateral counts but also its quality. That is why ETF providers place today greater emphasis than in the past on transparent collateral policies. Investors want to be reassured that collateral is of good quality and liquid enough to be easily sold without significant capital losses in the event of a default of the swap counterparty.

A further strategy to mitigate risks could involve using multiple swap counterparties in order to diversify credit exposure.

In case of buying a synthetic replication ETF it is convenient to check  the quality of the collateral. In Inbestme, if we invest in a synthetic ETF, we constantly check the quality of the collateral and the structure of the underlying swap to guarantee maximum safety for our clients.