The old investors’ advice to “Never invest in something you don’t understand” strikes for synthetic exchange traded fund.
A synthetic exchange traded fund is an investment that mimics the behaviour of an exchange traded fund through the use of derivatives such as swaps. The most obvious way to track an index is to own all (or most) of its component securities in the same proportion as that index. However the synthetic ETF can imitate an index without owning a single one of the benchmark’s securities. In fact, well-known providers such as Lyxor and db x-trackers are both swap based.
Why would an investor invest into a synthetic ETF when they could simply use a plain vanilla index fund?
The answer is that the swap structure provides a low tracking error. While most managed index funds follow their benchmarks closely, it’s not unusual for tracking errors to be a drag on returns. With a swap structure, the counterparty must deliver the return of the index precisely.
So why go to the trouble of actually owning the shares of an index when you can deliver its return using swaps?
However the reduction in tracking error comes at the cost of heightened counterparty risk. In the worst case scenario – counterparty default – the ETF’s source of return is cut-off and it’s time to fall back on the collateral.
Even though ETF must be backed by collateral worth at least 90% of its market value and in practice, ETF are often over collateralized – meaning backed up to 120% of its value in collateral – there is no requirement for collateral to be held in the same securities that the ETF tracks. It implies that the ETF’s collateral basket can include illiquid assets!
I recommend investors greater scrutiny of collateral pools to avoid being soaked up in a downturn by applicable haircuts!