While it is not as a big of a concern in the U.S. markets, investors should still be aware of how “synthetic” exchange traded funds operate.
Unlike traditional, or “physical,” index-based ETFs, synthetic ETFs, or Undertakings for Collective Investments in Transferable Securities (UCITS) in Europe, hold securities that are unrelated to the benchmark index through derivatives or swap agreements with one or more counterparties who have agreed to pay the return on the benchmark to a fund. Essentially, returns are backed by a counterparty instead of the individual components out of a benchmark index.
Compared to physical ETFs, synthetic funds hold collateral and swaps, has counterparty risk, incur management fees and swap costs, and may show tracking errors due to resetting of swap contract terms.
Counterparty risk refers to the potential risk that the party will not live up to their contractual obligations. A counterparty may put down collateral to help soften a potential default, but the European Securities and Markets Authority has been urging the industry to increase collateral exposure.
“Synthetic ETFs may make sense in certain instances, such as when investors wish to gain exposure to markets that are hard to access or strategies that are not easily implemented,” according to a Vanguard research note. “Still, we believe that these funds do have more counterparty risk than do physical ETFs, and that investors should be compensated accordingly through lower tracking error or lower costs (the latter of which can lead to higher expected excess return).”