What are synthetic ETFs and are they too risky?

Synthetic ETFs sound risky, but there are clear benefits to using them. 

To understand what a synthetic ETF is it is perhaps easiest to start with its opposite: a physical ETF.

A physical ETF buys the shares of the underlying index it is supposed to mirror. This means that if you use a Vanguard ETF to track the FTSE 100, Vanguard buys the shares held in the index in question. Vanguard is the legal owner of the shares and is afforded all the usual rights of a shareholder, such as being able to vote at board meetings.

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In contrast, a synthetic ETF is designed to replicate the return of the underlying index, just like a physical ETF, but without actually owning the shares of the index in question. Instead of buying the shares, the index is replicated through so-called swap transactions. This means that the ETF provider enters into an agreement with a financial institution that is then obliged to deliver the index return.

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These ETFs first appeared in Europe in the early 2000s. Since then, an increasing number of providers have started to offer synthetic ETFs. Such ETFs are often used for access to alternative assets such as commodities, less liquid markets including frontier markets, or specialist products such as leveraged or short ETFs. However, some providers use synthetic replication for normal, mainstream indices, with one reason being the tracking error tends to be lower, which is explained in more detail below.

How does it work?

The ETF provider (a company such as BlackRock, Vanguard or WisdomTree) enters into an agreement with a financial institution, usually a bank. The bank is called the ‘counterparty’.

The agreement takes the form of ‘swap’ contracts and essentially this means that the counterparty (the bank) agrees to pay the ETF provider the total return of the pre-decided index.

Emphasis should be placed on the total return here – it means that the counterparty pays both the share price appreciation and dividend payments of the index. So if the chosen index is the FTSE 100, the counterparty pays the ETF provider the amount the FTSE 100 has appreciated by, as well as the equivalent of all the dividends paid out in that period by companies on the index.

Why use synthetic ETFs?

There are reasons why some investors favour synthetic  ETFs. First, it is sometimes easier to use swap contracts to replicate the return of an alternative asset or a less liquid index.

However, even with normal mainstream indices there are advantages. ETFs are meant to track an index as closely as possible. Synthetic ETFs, with the use of swap contracts, are able to do this better, for the most part. ETFs often provide a return slightly below that of the index they are tracking, known as the tracking error. Synthetic ETFs typically have a lower tracking error. If you use a synthetic ETF, you are likely to get a return closer to the index it is tracking, as the counterparty has agreed to provide the total return of the pre-decided index. The difference can be small, but over time this adds up.

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On top of this, synthetic ETFs are often cheaper to run. One of the big draws of ETFs is that they are relatively cheap – the synthetic method helps to potentially make them even cheaper.

Are they risky?

Over the years, financial commentators have expressed concern about synthetic ETFs. First, the process is complicated and seemingly hard to understand. As a result, many investors have shied away from using synthetic ETFs on the basis that it is imprudent to invest in anything you don’t understand. Usually that is a sound principle, but in the case of synthetic ETFs it may be taking it too far.

One of the big risks of synthetic ETFs is so-called counterparty risk. This means the risk that the counterparty (the bank in the swap agreement) will not pay you, perhaps because they become insolvent, and fail to deliver their obligations.

During the 2008 financial crisis, some banks did fail, with many more coming close to the brink, showing how real counterparty risk can be.

But it is important to remember that financial meltdowns are rare, while banking regulation has improved significantly. So long as the ETF provider uses reputable counterparties, the risk is low.

How do I know if my ETF is synthetic?

The surest way to tell is to look at the ETFs “Key Investment Document”, or KID. These are documents that ETF providers are legally required to provide if they want to sell their products to UK investors. On interactive investor, they can be found in the ‘documents’ section, just under the performance chart, on the page of any ETF.

Within the KID, there is a section called ‘objective and investment policy’. This should tell you whether the ETF is physical or synthetic.

So, for example, if we look at the KID of the Lyxor FTSE 100 ETF Acc (LSE:L100), it becomes clear that it uses a synthetic strategy to replicate the performance of the FTSE 100. Under its objective and investment policy, it states: “The fund seeks to achieve its objective via indirect replication by entering into an over-the-counter swap contract.”

In contrast, if you look at the KID of the Vanguard FTSE 100 UCITS ETF (LSE:VUKE), you can tell that it is a physical ETF. In its objectives and investment policy section, it says the fund’s aim is to “track the performance of the index by investing in all constituent securities of the index in the same proportion as the index”.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.