Can Synthetics Survive?

From the outset, let me make clear my position, and my motive for holding it. I'm a UK-based IFA, who chose five years ago to specialise in exchange traded products for retail investors. That means I promote the “long only” funds traded in sterling, from the largest issuers to the smallest, without bias or favour to any of them. I leave leveraged, inverse and esoteric funds to professional investors.

Synthetics are sizeable and deserve some attention

Of all the 1,600 ETPs currently listed on the London Stock Exchange (including multi-currency lines), I judge there is a pool of 485 funds suitable for retail investors. Of those, as many as 218 are replicated synthetically, amounting to £28 billion out of a total of £114 billion, as of December 2013. This is still a sum of significance. My view is that both styles of replication deserve respect; and for one to succeed, the other need not fail.

Why I choose ETFs

Running my own , directly-regulated firm, I am familiar with pressures to simplify the advisory process, but without any leakage of integrity. Clients and IFAs alike prefer to buy largely popular funds with a well-known name, and be familiar with all the features of that fund.

So, even if a client wants an index-tracking investment, the easiest option might be to recommend a mutual fund. There are several dozen plain vanilla funds, which is fine for a background colour.

But what do you do when a client asks why some mutual index-trackers are shockingly expensive or that online stock brokers charge attractive flat-rate fees? You could tell them that ETPs are able to track more exotic underlyings, that UK-domiciled ETFs are exempt from stamp duty and can cost as little as 0.1 percent per year.

The fact is that ETPs run with vigour against all competition. Their six merits are:

Easy comprehension

Low charges

Favourable taxation

Scrupulous disclosure of risks

Transparency of contents

Continuously-visible performance

At this point physically replicated funds are the obvious first resort, and the field of funds is surely large enough and varied to meet the needs of even the most particular investor.

Against so strong a field of contenders, what unique selling point do synthetic funds have? For instance, are they always cheaper than their physical counterparts; or are they always closer to the index they track? No, they aren't. But this does not mean we can dismiss them as the Neanderthal version of ETP evolution, because they are already so thoroughly integrated in the ETP landscape.

If we look at my pool of 485 ETPs, in almost every filter there's a substantial dual presence of synthetic and physical. For example, among the 419 equity funds:

Let me first address the criticism that synthetics are dangerous due to counterparty risk. Counterparty risk is always present in one form or another and neither replication method is exempt. Also, some antagonists of synthetic replication are prone to overlook the fact that physical replication isn't perfect; especially when issuers choose to “sample” or “optimise”, which means not fully replicating the index and instead choosing certain stocks. This can costs down, but comes at a price for tracking difference.

Replication should be the last part of the filter, if the IFA wants to be thorough.

Seven circumstances in which synthetic replication is a valuable option:

1. Stocks of an index might be either illiquid or inaccessible; for instance China, Eastern Europe or global property companies.

2. An index contains so many stocks that issuers of physical ETF themselves have to apply 'sampling' or 'optimisation'; for example on indices like the FTSE All Share, the Japanese Topix, Europe small cap or a World index.

3. Funds with a small number of stocks: shipping; nuclear power; agricultural products and Mexico are all examples.

4. An all-commodities ETF, where I think physical replication would be absurd.

5. Where trading may suffer from poor communication, operate under a different business culture or political regime; for instance India, Thailand, Russia, or Turkey.

6. When steadiness of tracking difference is desirable. Some ETF issuers make a virtue of fixing the tracking difference so that investors will know in advance exactly what the costs will be.

7. An issuer offers multiple counterparties as an integral feature of the fund in these situations. This allows the investor to be more nimble and adaptable; which might be especially useful either at periodic rebalancing or when exercising a trading discipline.

To my way of thinking, the value of synthetic replication is equal to, and different from, the value of physical replication. To disparage one in favour of the other would be to nobody's advantage, and I pay equal respect to them both.

Between them, they offer choice and can peacefully co-exist. Issuers will continue to innovate, and that will shift the balance one way or the other. In the meantime, investor demand will be the ultimate influence as to the survival of synthetic replication.

Stephen Walters is an independent financial advisor and director of Edinburgh-based Dexterity.  www.whichETF.co.uk