By Rachael Revesz | 10 October, 2013

The European exchange-traded fund (ETF) market continues to prefer physically-replicated over swap backed products and several major providers are now trying to catch up with this trend.

Physically replicating funds have added €80 billion in assets since 2011, compared to just €10 billion for synthetic funds, and the trend shows no sign of waning. There are €173,120 million worth of assets in physically replicated ETFs as of August, compared to €90,625 million in synthetic structures.

Amundi. Source. Ossiam and ComStage are primarily synthetic providers, while major players like Vanguard, iShares and HSBC have more than 99 percent of their assets in physical ETFs. iShares, the ETF platform of BlackRock, has the largest proportion of market share in the European ETF industry.

NEW STRATEGY AT DEUTSCHE

Recognising this, two of the major synthetic providers are launching physically replicating product lines, ceding to market demand even as they argue publicly that the product structures are equivalent. Deutsche Bank and Lyxor have significantly expanded their physical line in recent years, with mixed results.

Deutsche Bank’s ETF platform, db x-trackers, has 99 percent of its assets under management in synthetic structures, according to company data published on 9 September. The provider has been building out its physical range, however, and has seven physical products to date, all launched this year. The first five have a combined total of €370 million of assets.

“Normally it takes 6-12 months for an ETF to gain traction and build up and obviously we’re in a very competitive market with some of those indices too,” said Manooj Misty, managing director and head of ETPs at Deutsche Asset & Wealth Management.

Mistry said the new physical ETFs this year were the first physical products they had launched against major equity benchmarks, but they had offered a few niche physical products on their platform since 2010. These failed to gain traction and were closed.

“What prompted us to launch more [mainstream physical products] was demand for that structure from certain parts of the market, which had clearly been influenced by the debate about physical versus synthetic products. Also, we felt we were at a point where we could bring the similar high operational standards to direct replication products, in terms of things like transparency and tracking, as we have traditionally offered.”

THE SATURATED DEBATE

The synthetic versus physical is, many providers feel, a well-trodden debate. There has been much regulatory heat around the so-called risks of synthetic structures, however this noise has died down since ESMA published its guidelines earlier this year, in July, finding both ways of replication robust.

Mistry added: “From the retail market perspective, institutions like private banks and those managing portfolios on a discretionary basis have shown a preference for physical replication.”

Last week Deutsche launched the MSCI Nordic and MSCI Turkey ETFs. both physically backed, to fill their product gaps. Mistry said there were more physical product launches in the pipeline.

“We’ve always said both replication structures can produce good products. For us now it’s very much determined on a product by product basis; if we can do it via physical replication then we are happy to do that, but if it’s better via synthetic then that’s fine too,” he said.

“In terms of our structure, if our physical product does securities lending then we have the same rules in place for counterparty exposure as with a swap-based ETF, where counterparty risk has always been tightly controlled. So from the investor perspective they should be almost indifferent. Both ways are robust and people can make up their own minds.”

ALL CHANGE AT LYXOR

Lyxor Asset Management is also building up its physical range. It has 16 physical funds with €2.2 billion of assets, out of a total AUM of €29.6 billion. The remaining 150 products are synthetic. Several funds, for example the euro government bond range, were switched earlier this year from swap-backed to physical structures.

Chanchal Samadder, director of UK and Ireland institutional ETF sales at Lyxor Asset Management said he was agnostic as to replication structure but there were certain asset classes that worked better under a specific replication type.

He said Lyxor would not rule out future fund replication switches in future.

“We will look at the market: we are very nimble and open to change. If we think a switch would lead to a better tracking error or total return or the market dynamic shifts we would be happy to change that [ETF] from a swap structure [to physical].”

PHYSICAL AUM ISNT EVERYTHING

But Michael John Lytle, chief operating officer at Source, said it was too easy to make sweeping generalisations based on the number of assets in physical versus synthetic structures. He said the best replication method depended on the asset class. Source offers physical exposure for precious metals and fixed income and synthetic exposure for commodities and equities.

“In our equity products we were number two last year for raising new assets, second to iShares, so we conclude that it’s not really as simple as a physical versus synthetic debate,” he said. “A good part is to do with your business model and who you are. An investment bank offering a synthetic product is different to us using various counterparties and making efficient use of derivatives. We also think carefully about how to build them to minimise counterparty risk.”

Lytle said it was clear the UK retail market favoured physical replication, but that this segment was only a small part of ETF assets.

ADVISERS PREFER PHYSICAL

According to data from Deutsche Bank, out of 35 European providers, 23 providers offer a heavier focus on physical products, including 17 providers who only offer physical products. However, there are still many more synthetic products – 762 – in Europe compared to physical ones at 550.

Alan Smith, chief executive of Capital Asset Management, said he saw two reasons for the current balance in the market. He spoke from the retail advisory side, which was a main target audience of, for example, iShares and Vanguard.

“In most areas the word “synthetic” has connotations of inferiority over “real” – physical – and this applies to the view on risk. Synthetic is viewed as being riskier by regulators, advisers and investors,” he said. “Also, compliance and PI [professional indemnity] insurance – many adviser firms are precluded from recommending synthetic ETFs and PI insurers will not provide cover in the event of a blow up, or will charge a significant premium for cover.”

The growing section of UK financial advisers picking ETFs will look mostly at physical funds, so it could be argued Lyxor and Deutsche have a lot of catching up to do, no matter their success elsewhere.