Vodafone Cash Distribution Highlights Synthetic ETFs’ Advantage

In the last few months we have seen more signs that synthetic ETFs are being bullied into submission, with the likes of Lyxor, db X-trackers and PowerShares converting their funds to physical replication.

PowerShares said it is not "useful" to have synthetic replication for large, liquid indices. db X-trackers claimed that the overriding reason for switching its products was down to investor demand.

But are providers bailing out of synthetic funds too early?

After all, synthetic funds actually have better tools to minimise costs and track an index more closely, especially when it comes to index rebalancing.

The most obvious case in point is the telecoms giant Vodafone disposing of its 45 percent stake in Verizon. The cash distribution is expected to amount to around £49 billion.

The index assumes the distributions are reinvested, and this is reflected in the index – as of yesterday – over a week before the payments are handed out to shareholders. This results in a temporary lag between the index change and the ETF receiving the cash. Therefore, the ETF has to replicate the index in some other way to prevent falling out of line with the benchmark and produce "tracking error".

This could be one instance where synthetic funds truly shine. With synthetic funds, the swap counterparty has committed to deliver the performance of the index, less fees, therefore in theory their tracking would be unaffected by the distribution. Physical ETFs have fewer ways to mimic the index as they make limited use of derivatives.

For physical funds, trading could be costly and the performance could suffer.

For distributing physical ETFs, like the UBS FTSE 100 ETF (GBP) A-dis, there can be a lag from when the ETF receives dividends from its underlying holdings to when it distributes this income to investors. Between these dates, the pending distribution may sit in an interest bearing account instead of being reinvested in all the index constituents. This results in cash drag, which essentially means that the money is going to waste in a deposit account if the stock market is rising.

"Cash drag will cause the fund to underperform its benchmark in the case that the index rises at a greater rate than the rate earned on cash during this time," said Hortense Bioy, director of passive fund research at Morningstar. "Likewise it will cause the fund to outperform its benchmark in the event that its benchmark index falls during this time. In both cases, cash drag is source of tracking error."

To avoid cash drag, physical ETF managers can take out a future or forward derivative contract, either on the entire index, or an individual stock, to gain desired exposure without increasing tracking error.

Ben Seager-Scott, senior research analyst at advisory firm Bestinvest, said: "If [the future is taken out] on the index, which is cheaper [than taking out a future on a single stock], the tracking error would be the difference between Vodafone and the FTSE 100, but we don't know how differently these are going to trade: it's impossible to tell in advance," he said.

Julien Boulliat, head of ETF portfolio management at Deutsche Asset & Wealth Management, said the use of a derivative is definitely the preferred route for sophisticated investors.

"It's the most simple, you are already set up with your broker and the cost of trading is relatively low. A future is a margin instrument, meaning you only need a fraction of the cash upfront," he said.

A futures contract on the S&P 500 worth $92,000 requires an initial margin payment of $4,757. Margin payments are paid as insurance by the buyer of the contract, since he is not paying upfront, to lock in the purchase or sale of an asset at a certain price in the future.

The dividends from Vodafone are paid in US dollars so portfolio managers can take out a future to mimic the equity exposure and a foreign exchange forward to hedge against currency risk, which exists between the ex-dividend date and the distribution pay date, if the index currency is not in US dollars. A physical ETF manager who gets his derivatives right can significantly reduce tracking error.

Accumulating physical ETFs, like the iShares FTSE 100 UCITS ETF (Acc), are expected to reinvest all dividends in stocks or futures and there is no reason for them to hold cash.

But with synthetic ETFs, both accumulating and distributing, the performance risk is taken on by the swap counterparty who has a broader tool kit to replicate the index. For example, if you take the Amundi FTSE 100 ETF (C1UG), it uses a swap from French bank BNP Paribas.

Adam Laird, passive investment manager at online broker Hargreaves Lansdown, explained that in this instance BNP will hedge the swap by trading on their own book.

"If they decide to rebalance their hedge differently and make money then BNP wins, and vice versa if they make the wrong decision. For this reason, swap based ETFs are more accurate," he said.

However, it's not as simple as saying that synthetic funds get rid of the headache of tracking error by outsourcing it. A good physical manager will minimise tracking error and can also use stock lending to make up any difference.

Seager-Scott added that as more investors start looking at emerging markets, single country funds and smaller parts of the market, tracking error on physically replicated funds will become more noticeable.

"If investors look at that in a more meaningful way, and if there are jitters in the market, like concerns over China, this could provide tracking error and, even worse, the ETF trading at a discount to NAV [net asset value]," he said.

This worst case scenario is unlikely with Vodafone, as the FTSE is a large, blue chip index that trades in the same time zone as the underlying equities.

And although cash distributions of this size are rare, this could be one area where physically replicated funds lose out to synthetic replication, and it is definitely something investors should be aware of.