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Let’s Get Physical

Why Are Synthetic ETFs Losing Favour? And What’s Brussels Got to Do With It? Stephen Spurdon Reports

It’s been on the cards now for a couple of years, actually. Ever since the Bank of England first waved a big yellow flag about synthetic exchange traded funds in its June 2011 Financial Stability Report, the market has been aware that consumers were likely to start worrying about the risks of derivative-based funds – and that some sort of a return to old-fashioned asset-backed  ETFs would soon be on the cards.

Back in May 2013, Deutsche Bank had said that physical ETF AUM in Europe had grown by 35% during the previous two years, compared with just 18% for synthetics. But the speed of the trend in the last twelve months has taken everyone’s breath away. Last year, worldwide sales of physical ETFs outpaced synthetics in many areas of a market where derivative-based funds had once dominated. Blackrock’s iShares range of ETFs, which are overwhelmingly physical, attracted a colossal $59 billion of new money, while Vanguard pulled in $55 billion and State Street brought in $34 billion.

But Deutsche Bank’s predominantly synthetic funds saw a net outflow of $6.4 billion, which was one of the reasons why the group’s year-end results were so dismal. (It was also one of the reasons for a major change of corporate heart – see below.)

Change of Heart, Choice of Style

These days the physical bandwagon seems to be well and truly rolling, with several of the industry majors moving into new territory with new or amended offerings. But, interestingly, there are still noticeable differences in approach.

Take, for example, Lyxor, a major provider with a long and distinguished record in synthetics, which launched a series of four physical fixed interest ETFs at the end of 2012, followed by another four in May 2013. And then consider Deutsche Bank, which made the headlines in December 2013 with an announcement that it was to convert 18 of its largest dbX ETFs, including all the FTSE, Dax, EuroStoxx indices and so forth, from synthetic to physical.

You might suppose that the two had come to the same conclusion about the growing inevitability of physical ETFs. But you might be wrong.

DB’s choice was more a matter of cloning its existing synthetic funds so as to give all investors a straight choice between the two, says Lyxor’s Ben Thompson, Director, Business Development, Listed Products & Lyxor ETF. But Lyxor’s approach has been more “pragmatic”.

“What that means is that, ignoring the actual tracking methodology, we focus on which method gives the best performance….When we launched our four funds last year on the fixed income side, full replication was the obvious way to keep risk low. But when it came to large cap developed equities, the story was more mixed, and straight physical was not necessarily the most efficient way. In these situations, a physical approach with securities lending or physicals with a swap gives you a similar outcome.”

Some continental European trackers have worked best as physicals, says Thompson, but that approach wouldn’t do at all for emerging markets or for smart beta solutions, where synthetics continue to be the best way forward. “In some situations,” he says, “synthetics with a swap can improve efficiency by as much as 2% or 3% a year.”

Lyxor’s European ETF funds (Eurostoxx 50 and MSCI Europe), however, are “physically replicated with a securities lending element to provide additional performance,” says Thompson. The point of this hybrid, as distinct from a swap-based ETF, is that it leaves all the solid physical assets with the issuer and minimises dependence on external counterparties.

Synthetics And Other Exotics

There was a time when traditional synthetic replication, involving a swap with a counterparty which was then obliged to match the return on the underlying index, seemed the height of sophistication. But the scope of these products has expanded beyond anything that their original progenitors might have envisaged.

Nowadays the range now includes ETFs that allow investors to go short of these markets – as well as others that offer multiples of long or short positions with use of leverage. And then there’s that apparent contradiction in terms, the ‘actively managed ETF’, which is likely to be built on a non-standard index that may well be weighted in a particular way so as to achieve a particular end under particular conditions. (It may, for instance, favour smaller companies, or companies that pay big dividends, or high-risk recovery stocks.)

But if you really want to see just how exotic ETFs can become, just look at those listed in New York, where traders can acquire leveraged exposure to the S&P 500 Vix index in multiples or inverse varieties: basically a pile of investment bank paper balanced on top of ‘market sentiment’!

After the Storm

The synthetic story sold well during the early years of the 21st century. Synthetic providers could boast of reduced cost and greater tracking accuracy, and they could greatly expand the range of market indices that they could follow. ETFs could now be used to track emerging markets that physical replicators had been forced to ignore because of the cost of obtaining full replication.

So the message to advisers and retail investors was that a world of diversity and risk spread could be on offer with a few clicks of your mouse – with ETFs effectively hitching on the back of the internet boom or the late 90s/early noughties. But it was bound to run into trouble.

It was, of course, the financial crisis of 2008 which highlighted the interconnectness of risk, and which saw synthetic products received a lot of attention, not least in respect of counterparty risk. (A concept which seemed oddly irrelevant to many, as late as 2007.) But one way and another, it soon became apparent that ETFs weren’t quite so simple after all.

Day of the MiFID

That was certainly one of the crucial issues for the European Union, which has spent the last four years or so in a wholesale re-examination of the rules under which financial products can be marketed within the EU consumer space. The resulting plans for a new regime, known loosely as the Markets in Financial Instrument Directive (MiFID II), has finally gone off for finalisation after a mere two years of delays over precisely this sort of question. When is a simple investment not as simple as it seems?

Now, ETFs are by definition ucits compliant. And, according to EU practice, a ucits is by definition a ‘simple’ investment, suitable for purchase by even the most unsophisticated investor. So what are we to make of a shorting ETF, or an ETF whose value depends on the continued probity of some far-distant counterparty? Should it be banned, or restricted so that the unsophisticated can’t get at it?

We’ll put you out of your misery. The final draft of the MiFID II document, which went for approval on 14th January 2014, showed no sign of wanting to demonise synthetic or ‘complex’ ETFs. But it was clear that it had forced the Eurocrats into a serious contemplation of how ‘simple’ a ucits legally needed to be.

What MiFID II Says About ETFs

As we’ve seen, there has been a market reaction to the concerns raised about risks associated with synthetics – and, although longer in coming, the reaction of the regulators is now upon us. 

It had been widely feared that MiFID II, the review of the original Markets in Financial Instruments Directive (MiFID, 2007), would result in punitive restrictions on any activity highlighted during the financial meltdown – such as over-the-counter derivatives and high speed ‘algorithmic’ trading.

And, since the aim of MiFID II was to increase transparency and stability, fears had been raised that some synthetic ETFs were of such complexity that they should not be sold directly to retail investors. The threat appeared to be that synthetic ETFs would have to be named ‘complex ucits’ and thus not be available for execution-only deals.

But by the time that MiFID II had finally made it through a wearying four-year process consultation and debate between the European Commission, the European Securities and Markets Authority (ESMA) and the European Parliament – the so-called trialogue – most of these concerns had evaporated.

As far as we can tell at present, all that the legislation appears to require of ETF providers is greater clarity in both prospectus and key information documents, regarding the nature of the investment and the techniques used for their management.

There are areas of the legislation relating to derivatives trading that may yet have an impact on the management of synthetic ETFs – but we’d have to say that the precise effect is as yet unclear. The main thing seems to be that derivative-linked Ucits will remain ‘non-complex’. 

So far so good. But it does need to be remembered that the directive still has to be interpreted and implemented by ESMA, as well as national parliaments and regulators. So the devil may not just be in the detail, but also in its implementation. MiFID II is expected to become law in the second quarter of 2014 and become compulsory at the end of 2016.

During 2012 the ESMA issued ucits guidelines on how ETFs should be described in prospectuses, which were mainly concerned with clarification of synthetics to investors. However, there was a heavy emphasis on stock lending practices of physical providers under the headline of ‘efficient portfolio management techniques’. This, according to one industry insider, effectively neutered the debate between synthetics and physicals.

The Road Ahead

So, to return to our theme. Yes, there was an initial concern about counterparty risks in synthetics and potential contagion. And yes, the public are now voting with their feet in favour of physicals. But the ETF providers are also mindful of their own need for a spread of risk in terms of what they’re offering. It was inevitable that the overwhelming dominance of iShares in the physical ETF marketplace had to be challenged.

As it happens, the big worry – that synthetics might find themselves restricted – is off the cards. But it’s simply logical that we’re going to be hearing much more about physicals in the coming years. Simple can be best.

 

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