There are two main types of ETFs, each with its own followers and detractors. As we will see, these two groups differentiate by their replication method (physical replication and synthetic replication). Replication is the way to invest the capital in order to gain exposure to the performance of the chosen index. Guide Finances has a very strong opinion and strongly recommends physical ETFs, even if in some exceptional cases, synthetic ETFs may be more appropriate.
What are the two methods of replication?
There are two types of replication:
- Physical replication is simple: This means that the fund will directly hold the shares of the index companies. This is the preferred approach in the United States and the main approach of Vanguard and iShares ETFs.
- Synthetic replication means that the ETF manager will use derivatives to replicate market performance. This method is used by some European investors, such as Amundi in France, to gain access to international equities for tax-optimized retirement plans.
There are then two main ways to achieve a physical replication of the index: Full replication, which means the fund will hold shares of all the companies listed in the index. On the other hand, if index funds use sampling, they will only hold a portion of the total companies in the index.
Counterparty risks for synthetic ETFs
Concerning synthetic replication, you must consider the risks of a counterparty failure, since ETF issuers rely on investment banks (their counterparty) for their derivative needs. The scenario of a custodian failure may also apply to physical and synthetic ETFs, but these have always been able to organize themselves in an orderly manner and the transfer of assets to a new custodian would not in itself be a problem.
In the case of a bankruptcy of a counterparty outside the investor’s country, foreign recognition of the bankruptcy and practical enforcement of the bankruptcy may be a problem. For Amundi’s synthetic ETFs, for example (the counterparties are currently BNP Paribas Arbitrage for equity ETFs and Société Générale CIB for bond ETFs), these French counterparties, i.e. in the same jurisdiction, would be an advantage in the event of bankruptcy. On the other hand, in the event of turbulence, government support would probably have only a limited effect. Indeed, bank resolution plans in Europe (including in the UK) differentiate between activities that are crucial for a country’s business (e.g. infrastructure services, payment services and services to small savers) and activities that are not crucial for a jurisdiction (e.g. investment services for wealthy clients, foreign clients or transactions). Unfortunately, it seems that the counterparties of synthetic ETFs are part of this second category. Therefore, they would not benefit from a de facto state guarantee. As they are not part of the core business, you can expect them to fall outside the priorities of the resolution plans of systemic groups.
Your jurisdiction will influence your choice of ETF
If the investor relies on a portfolio of ETFs to cover most of his pension needs (as is often the case in the US or in the case of early retirement in Switzerland), increasing his exposure to a counterparty does not seem to be a worthwhile risk. In the case of a bankruptcy of the swap provider, in addition to the loss on the derivative, a loss between the label of the ETF and the asset pool could occur. As the counterparty’s own requirements determines this pool, an even higher difference in case of a strong decorrelation between the two legs is possible.
If your jurisdiction (as in the case of the PEA in France) does not allow for a more diversified investment on non-European indices by means of physical ETFs, an investment in synthetic ETFs seems justified.
For an individual asset base mainly composed of ETFs, our preference is for a physical replication in order to avoid the risk (small, but with material consequences) of a counterparty bankruptcy resulting in a strongly reduced recovery (between the asset pool and the loss on derivatives). This is an additional risk that is not compensated either by better performance (tracking errors are similar) or by the lower fees of synthetic ETFs. This only serves the investment bank, often related to the issuer of the synthetic ETF.
The important thing is to avoid ruin and you will not end up on the street by investing in synthetic ETFs from reputable providers. Thus, synthetic ETFs can be justified in some cases (based on the pension regulations of some European countries) and if the investor is comfortable with the idea of losing his exposure to the index in case of bankruptcy of the counterparty. However, we consider that in the overwhelming majority of cases, taking risks without a proper compensation is not acceptable: this being the case with synthetic ETFs and we avoid them. We prefer physical ETFs from the world’s most established providers, Vanguard and iShares.