Guide to ETFs: How synthetic ETFs work

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29 Oct 2018 | 4 min. read

Synthetic exchange traded funds (ETFs) use complex derivative products to replicate an index. They are classified as Specified Investment Products. Find out how the different synthetic ETF structures work and the risks of each.

Key takeaways

  • Synthetic ETFs don't directly own the assets in an index, but use derivative products to replicate index returns.
  • There are swap-based ETFs (funded and unfunded) and access product-based ETFs. Each type of structure has its own specific risks.

What are synthetic ETFs?

Exchange traded funds (ETFs) can be structured as cash-based or synthetic ETFs.

Unlike cash-based ETFs, synthetic ETFs don't directly own the assets in the index they are tracking. Instead, they use derivative products to replicate index returns. These derivatives include swaps and access products (for example, participatory notes).

Tip

On the SGX, synthetic ETFs are tagged with an ‘X’, which appears next to the ‘@’ used to mark Specified Investment Products (SIPs). You'll see the symbols 'X@' beside the ETF's trading name.

How the structures work

Here's how the swap-based ETFs (unfunded and funded) and access product-based ETFs work.

Swap-based ETF (unfunded structure)

In an unfunded structure, the ETF buys and holds a basket of securities. The basket of securities may be completely unrelated to the index the ETF is tracking. The ETF then enters into a swap agreement with another entity known as the swap counterparty.

Under a swap agreement:

  • The ETF will pay out the return it earns from the basket of securities to the swap counterparty
  • In exchange, the swap counterparty pays the index’s return to the ETF

The ETF holds and retains control of the basket of securities even if the counterparty defaults. In addition, the ETF’s exposure to its swap counterparty is usually limited to 10% of the ETF’s net asset value.

This means the ETF could lose up to 10% of its net asset value due to unpaid obligations from the swap counterparty. Additional losses may still be possible, for example, if the basket of securities is liquidated under adverse market conditions.

Swap-based ETF (funded structure)

In a funded structure, the ETF passes its cash holdings (pooled investors’ monies) to a swap counterparty. In exchange, the swap counterparty pays the returns of the index the ETF is tracking.

The swap counterparty will post collateral with a third party custodian. The collateral is held to offset the ETF’s exposure to the counterparty. The securities making up the collateral may be unrelated to the index the ETF is tracking.

Generally, collateral posted by the swap counterparty should reduce the funded ETF’s net exposure to the counterparty to not more than 10% of the ETF’s net asset value.

In the event that the counterparty defaults on its obligations under the swap, the funded ETF will suffer a direct loss of the difference between the index value and the value of the collateral. The funded ETF could suffer additional losses if the collateral is liquidated under adverse market conditions.

Access product-based ETF

In an access product-based ETF, the ETF invests in participatory notes (P-notes) or other derivative products that replicate the performance of the index.

This structure has been used for indices on restricted markets such as China or India. For example, participatory notes linked to a basket of Chinese A-shares may be purchased and held by the ETF. As such, the ETF would be exposed to the counterparty risk of the participatory notes issuer.

What are the risks?

There are risks specific to each type of structure.

Swap-based structures

The risks include:

Counterparty risk

If the counterparty defaults, you could incur significant losses even if the underlying index is unaffected. Your loss will depend on the ETF’s exposure to the swap counterparty.

Concentration risk

This arises if the ETF is significantly exposed to a single swap counterparty or very few swap counterparties.

Conflict of interest

This arises if the same financial institution (or its related party) takes on multiple roles as the manager, swap counterparty, index provider, and market maker of the ETF. If so, the possibility of conflict of interests arises.

Collateral risk

If collateral is provided, there is a risk that the value of the collateral may decline after a default by the counterparty. Also, the composition of the collateral held may have no bearing to the investment objective of the ETF. There may also be difficulties for the ETF to enforce its rights to the collateral.

Access products-based structures

The risks include:

Counterparty risk If the access product issuer defaults, the NAV of the ETF may fall, even if the underlying index is unaffected. Your loss will depend on the ETF’s exposure to the access product counterparty.
Concentration risk This arises if the ETF is significantly exposed to very few access product issuers. In some instances, the ETF may be exposed to only a single issuer.
Tracking error This may be greater for access products because the structure has potentially greater inefficiency. For example, access product commissions and maintenance charges may be levied on the ETF for each purchase or sale of the access products.
Access products have limited duration Access products such as P-notes are of limited duration and may be settled automatically after a certain number of years after their issue. The ETF may be unable to renew the term of the P-notes it holds.
Conditions governing foreign access to restricted markets may change The access product issuer may lose access to the underlying shares or to additional shares. If additional shares cannot be obtained, the ETF cannot create more units. This may affect the price of units relative to the NAV.
Collateral risk If collateral is provided, there is a risk that the value of the collateral may decline after a default. Also, the composition of the collateral held may have no bearing to the investment objective of the ETF. There may also be difficulties for the ETF to enforce its rights to the collateral.

The bottom line

Investing in ETFs allows diversification; you may easily gain exposure to an index and its underlying assets. With synthetic ETFs, however, this exposure is achieved using complex derivative products that carry specific risks. It's not done by buying the assets directly.

If you are not comfortable with such a structure, you may want consider cash-based ETFs instead.

See also: Understanding exchange traded funds

Last updated on 09 Nov 2020