Deep dive into ETF’s with Invesco Part 3: Synthetic ETF’s
In this third and last article of the series “Deep dive into ETFs with Invesco” we deep dive into the synthetic ETF with Invesco, one of the world’s biggest providers of synthetic ETFs. The company's synthetic ETFs are available in a variety of markets around the world, including Europe, the United States, and Asia.
The Synthetic ETF
The synthetic ETF differs from the physical ETF in the manner of how an index is replicated. A physical ETF holds all, or a representative basket, of the stocks in the index to replicate its return. A synthetic ETF, however, makes use of financial contracts called swap agreements. In the context of an ETF this means that the ETF issuer is promised to receive the return of the index it is trying to replicate in exchange for a predetermined rate or other financial return. There are two main categories of synthetic replication strategies in ETF’s: the funded swap and the unfunded swap. The difference in the types of strategies is dependent on the way that collateral is held by the respective parties.
The unfunded swap is the most popular method of synthetic replication and works as follows. Say that you, an investor, want exposure to the stock market of Saudi-Arabia. One way of achieving that goal is through a physical ETF. In that case an ETF issuer sets up an ETF and buys the stocks of the Saudi- Arabian index. You subsequently buy the ETF shares and get exposure to the Saudi-Arabian market via the stocks that the issuer holds for you. However, the Saudi-Arabian stock market can be a difficult market to invest in, and physically replicating the index may therefore prove to be a costly endeavor. The unfunded swap method allows the investor to get the same exposure to the market but much more cheaply. The issuer now approaches a swap counterparty (for example a large bank) in order to agree to a swap agreement. The swap counterparty in this case already has the desired stocks on their balance sheets and wants to get rid of the exposure. The issuer buys a basket of large cap stocks as collateral and agrees to swap the return of that basket of stock with the Saudi-Arabian stocks. In this way the bank is able to hedge its exposure while the issuer is able to cheaply offer their ETF investors exposure to the Saudi-Arabian stock market. The reason the costs are so low is because no stocks have to be bought or sold. Simply the difference between the return of the index and the basket of collateral are exchanged between respective parties.
A funded swap operates in many regards similar to an unfunded swap but differs in the way that the collateral is held. In the case of a funded swap, the ETF issuer provides the swap counterparty directly with the cash of the investors. The swap counterparty then deposits this cash with an independent trustee who holds it on behalf of the ETF issuer. The collateral is in these cases therefore technically the property of the ETF and, as such, provides investors with recourse should the counterparty fail.
Benefits and risks
Using synthetic replication to construct an ETF has both advantages as well as disadvantages. The biggest argument in favor of using synthetic replication for index investing is the low management costs. As no physical assets have to change hands, the ETF can be managed at very low costs. The main risk of synthetic replication is counterparty risk which refers to the possibility of the swap counterparty to default. This causes the investors to lose their money. There are however several ways to mitigate this counterparty risk by ways of multiple counterparties and strict UCITS regulation1. Using multiple counterparties results in a better diversification of risk for possible defaults. Furthermore, UCITS regulation dictates that an issuer has to hold at least 90% of the value of the swap as collateral. Furthermore, the swap agreements resets when certain criteria are met, or events take place such as the creations and redemptions of ETF shares. Issuers often apply these rules even more strictly than what the UCITS regulations prescribes in order to minimize risks for investor. The popularity of the synthetic ETF has been on the rise with ETF issuers realizing the upside of the low costs and the various way to limit the risks by ways of multiple counterparties and strict regulations.
Invesco is one of the world’s leaders in the domain of synthetic ETF’s. On their website you can find their different ETF products and download additional information such as constituents, counterparties, and fund costs. The popularity of synthetic ETF’s is increasing with more ETF issuers realizing the upside of the investment tool. This article concludes the series “A deep dive into ETF’s with Invesco”. If you have any questions left or you would like us to explore other topics, please do not hesitate to reach out via email (email@example.com) or via our IG (@financialcareerplatform / @fsrotterdam).
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