More complex ETFs

As the ETF industry has grown, more complex ETF products with different risks have been created, such as ‘synthetic ETFs’. Synthetic ETFs can be riskier than physical ETFs .

Here are some important things to consider before you invest.

What are synthetic ETFs?

Like physical ETFs, synthetic ETFs are a type of managed investment scheme that can be bought or sold like shares.

Synthetic ETFs rely on synthetic rather than physical holdings of the underlying shares or other assets whose performance they are aiming to replicate. This means that as well as directly owning the underlying assets they use complex products called derivatives provided by financial institutions to achieve their investment objectives.

Synthetic ETFs may be used by investors when it’s impossible or expensive to buy, hold and sell the underlying investment in another way. For example individuals can’t buy and hold commodities, but can invest in a commodity ETF, which may be synthetic in nature.

Synthetic ETFs traded on the ASX Quoted Assets (AQUA) market must have the word ‘synthetic’ in their title, so you can easily identify them.

Compared with physical ETFs, the prices of synthetic ETFs can be more closely matched to changes in the value of their underlying investments with minimal ‘tracking error’ before fees and taxes. But in return for reduced tracking error, investors take on credit risk associated with the ETF derivative counterparty.

What you need to know before you invest

Synthetic ETFs have many of the same features and risks as physical ETFs, such as pricing errors, fees and costs and passive investment strategies. (See exchange traded funds for more information.) But synthetic ETFs also have unique features and risks to be aware of.

Counterparty risks

Synthetic ETFs enter into contracts with third parties, or counterparties, which are usually investment banks. Your returns depend on the counterparty being able to honour its commitments to the ETF.

While synthetic ETFs may or may not buy the shares and other investments that they try to match, they also use complex financial instruments known as derivatives such as ‘swap agreements’. In a swap agreement, a counterparty such as an investment bank agrees to pay the difference between the value of the ETF’s assets and the value of the assets or index it is designed to track.

When the synthetic ETF enters a swap agreement, this creates counterparty risk. The swap fees may or may not be included in the ETF’s ‘management fee’.

Check the product disclosure statement (PDS) for information about swap fees and other costs.

Before investing in an ETF, check its PDS for financial information about the counterparty and how the issuer monitors and manages counterparty risk. The higher the derivative counterparty exposure level, the greater the proportion of the ETF’s value that will be exposed to counterparty risk.

Requirements in Australia

In jurisdictions such as the European Union there can be significant risks in synthetic ETFs’ derivatives and swap arrangements.

However in Australia, ASIC has worked with the Australian Securities Exchange (ASX) to reduce some of these risks, including by introducing specific requirements for synthetic ETFs available to date in Australia.

Another requirement is that counterparties for any ‘over the counter’ derivatives used must be Australian deposit taking institutions (ADIs) or an overseas equivalent (or have the benefit of an unconditional guarantee from one of these entities).

It is still possible that counterparty exposure could rise to an unacceptable level in exceptional circumstances. If this happens, the ETF issuer must take action as soon as possible to restore counterparty exposure to normal levels (for example, by requiring the counterparty to transfer cash or other liquid assets to the ETF). But if the counterparty fails financially and can’t pay up, investors could lose more than 10% of the value of the fund.

Specific risks with commodity ETFs

Most ETFs that track the price of commodities (such as oil or agricultural commodities) are synthetic because they track the futures price of a commodity or index rather than buying and tracking the price of the commodity itself.

But sometimes the price of futures, and therefore the ETF’s price, may vary from the value of the actual commodity. For example the price of oil indexes based on oil futures may differ from the ‘spot price’ for oil.

Some commodity ETFs also invest directly in futures contracts, which need to be replaced by other futures contracts when they expire. In certain circumstances replacing these contracts can be expensive, reducing the value of your ETF investment.

Before investing in a commodity ETF, understand whether it aims to track the current commodity price or the futures price, and whether it invests in physical assets (commodities) or futures contracts.

Inverse and leveraged synthetic ETFs

Other types of synthetic ETFs are available outside Australia, including ‘inverse’ and ‘leveraged’ ETFs and products that combine these features. Some of these overseas products may be available through brokers in Australia. If you’re considering investing in them, pay extra attention to the risks and note that Australian rules to reduce the risks of synthetic ETFs may not apply.

Inverse or leveraged synthetic ETFs from an overseas exchange are designed for extremely short-term trading. Because their prices are reset at the end of each day, they generally shouldn’t be held for longer than that. When held for more than one day, cumulative returns on leveraged and inverse ETFs can start to diverge from the cumulative returns on the assets they are designed to track.

A number of overseas regulators have raised issues about the potential market impact of these ETFs and whether they are appropriate for all types of investors.

Inverse ETFs

Inverse ETFs aim to deliver the opposite performance of the reference index on a daily basis. An inverse share index ETF would seek to give a positive return over a day when the share index goes down. On a day that share index increases, the ETF should lose value.

For example if a share index rose by 5% on a given day, the value of a unit in an inverse ETF over that index could be expected to lose 5% of its value.

Leveraged ETFs

Leveraged ETFs aim to deliver a multiple of the performance of the reference index on a daily basis. For example a US share index ETF with double leverage would aim to provide a 10% return on a day when the market increases by 5% on that day. Conversely if the market falls by 5% in a day, the ETF investor could expect to lose double that amount, or 10% for the day.

Warning

While leveraged and inverse ETFs may seem similar to other ETFs, they are much riskier for retail investors. They ‘reset’ at the end of each trading day, so if you invest for longer than one day your investment returns can differ significantly from the returns of the assets or index the ETF is designed to track. You could lose out even if the underlying investment delivers a positive return.

Synthetic ETFs can be risky. Make sure you read and understand the PDS, and always diversify your risks by using a range of different providers rather than putting all your eggs in one basket.