Synthetic ETFs Still Have A Place

db X-trackers started switching 18 ETFs to physical this year. Does this herald the end for the synthetic ETF?

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Reviewed by: Rebecca Hampson
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Edited by: Rebecca Hampson
In early December last year, Deutsche Asset and Wealth Management announced that it would be converting 18 of its swap-backed exchange traded funds to a physical structure from this week.

Was this a revelation? Not really. But it has prompted market watchers to debate whether the swap-backed ETF has reached the end of its shelf life.

It is no surprise that, yet again, the swap-backed (or synthetic) ETF is taking a hammering. Those familiar with the ETF market will remember the ferocious debate three years ago over synthetics versus physical, with chiefs Larry Fink, from iShares, and Alan Dubois from Lyxor, engaging in open battle.

db X-trackers, who at the time were a dominant synthetic provider in Europe and Asia, remained remarkably quiet during the furore.

According to db X-trackers the overriding reason for switching these particular products was down to investor demand.

Manooj Mistry, head of exchange-traded products in Europe, the Middle East and Africa at db X-trackers, said that in certain investor segments the retail facing institutional market, namely private banks and wealth managers, and funds of funds, want physically-backed ETFs.

"This is for several reasons, but we suspect that the most obvious answer is that physical ETFs are easier to explain," he said. "It takes more time to explain a derivative-backed ETF to ensure that the end investor really understands it."

The market already debated the risks associated with the structure of ETFs in 2011, and the hangover is the perception that synthetic ETFs are more risky. There is ample evidence that this is not true, backed up by guidelines from regulator European Securities and Markets Authority, but it is clear that the perception remains.

Data from ETF consultancy ETFGI shows just how unpopular synthetic funds have been. While the data for 2013 is not in yet, 2012 figures showed the synthetic market is barely a tenth the size of the physical market, in terms of net inflows. Physical ETFs had net inflows of $17.7 billion, compared with only US$1.7 billion received by synthetic ETFs.

Last year was also a year db X-trackers would probably like to forget after investors took $4.6 billion out of its ETF business, according to a piece in The FT by Madison Marriage.

So, does this mean that the synthetic ETF has had its day? Or is it simply hyperbole because people balked at the word 'risk'? Or is it because an ETF issuer has done something different and tweaked their business model? After all, isn't that what all good businesses have to do in order to remain successful?

The argument for synthetics is still playing out. But, encouragingly, the aforementioned FT article shows that synthetic providers Amundi and Source had inflows of $1.2 billion and $2.9 billion, respectively.

This suggests that the synthetic ETF may not be the sole cause of db's fall from favour over the last two years. It is also important to remember that the German provider is still ranked second in Europe by assets under management.

Mistry also argues that swap-backed ETFs still have a place. "They still have a place and we still believe in them. We will continue to launch them on a case-by-case basis," he said.

"With investors that may have a preference for physical, we often see they are happy to use synthetic ETFs when there is no physical alternative. For example, in emerging markets, some fixed income products and some smart beta products," he added.

There are also some smart beta products that can only be used with a derivative, in which case synthetics are the only option.

For example, if you want to access a smart beta long/short strategy (DB Platinum IV Equity Risk Premia fund is one example), you have to use a derivative to provide the exposure while meeting the UCITS requirements.

db X-trackers also launched a synthetic fixed income ETF in August, which has had a positive reaction from clients, according to Mistry.

The question now is whether db X-trackers will convert all of its products to physical?

"We don't have any fixed plans for how the future will pan out. If it were efficient for the investors to offer all our products as physical then we would do it. Similarly, if it wasn't then we would not," says Mistry.

However, tracking in less liquid markets is one of the areas where synthetic ETFs can be superior to physical. Data shows that certain emerging market synthetic ETFs produce tracking performance that is more stable than with an equivalent physical ETF. This is also the case in certain alternatives, such as broad commodity ETFs, which can only be done with the use of synthetic replication.

Mistry points out that the converted db X-trackers products track mainstream, liquid benchmarks.

"We switched them now with the benefit of having observed the performance of a small number of physical ETFs we launched late last year on major equity benchmarks," said Mistry. "These have performed well in terms of tracking, so we can demonstrate that our switched funds will similarly be quality trackers."

The first three that converted in December 2012 included the db x-trackers FTSE 100 UCITS ETF (DR), the db x-trackers Euro STOXX 50 UCITS ETF (DR) and the db x-trackers Euro STOXX 50 Ex-Financials UCITS ETF (DR), which is based on a new index from STOXX.

It is clear that physicals will prevail, but those investors in synthetics seem likely to stay where they are. While synthetics cost less and largely offer better tracking error than physicals, it would just help if we could explain the use of a derivative more easily.