The majority of Europe-listed ETFs these days are swap-based and most European investors are aware of the difference between physically replicated and synthetic ETFs. But in other parts of the world, the distinction is not yet widely understood, while regulation remains much looser.

Synthetic ETFs are now widely used in Asia. In Hong Kong, for example, 16 ETFs now use full replication or representative sampling, while 49 funds are synthetic. Singapore is seeing a similar shift. Some Asian synthetic ETFs are structured to be compliant with Europe’s UCITS III rules, which limit total counterparty exposure to 10% of a fund’s net asset value.

In a standard UCITS III-compliant synthetic ETF, such as those offered in Asia by Deutsche Bank and Lyxor, the collateral is generally not the same as the assets the ETF is supposed to be tracking; indeed, for China A share ETFs the restrictions on investing in the Chinese mainland market mean that the collateral has to differ in nature from the A shares in the index itself.

That means that the risks with a synthetic ETF are not solely confined to the uncollateralised exposure, which is capped at 10% of NAV. If an ETF did need to liquidate the collateral as a result of the failure of a swap provider, market movements and a lack of correlation between the collateral basket and the index might lead to a further shortfall when the collateral is sold.

In addition, having an ETF manager, swap counterparty and calculation agent from the same group is not ideal. Nonetheless, the UCITS III rules do at least result in a certain standardised level of risk management and transparency in a form that is not too difficult for investors to understand.

Other Asia-listed A share ETFs take a different approach: instead of a swap with the fund provider, they invest in ‘A share access products’. These are derivatives issued by third parties, and are designed to track the performance of a basket of A shares. The issuer is usually a major bank such as Citigroup, UBS or HSBC that has a Qualified Foreign Institutional Investor quota for investing in shares listed in mainland China.

A share access products are unsecured, general obligations of the relevant counterparty, meaning that investors are taking a significant bet on the health of the individual issuers. More importantly, and by contrast with UCITS-compliant funds, in most A share ETFs there is no cap on the maximum uncollateralised exposure.

To see what this means in practice, take a look at the iShares FTSE/Xinhua A50 China ETF, the oldest and by far the largest of the ETFs tracking China’s A share market. The fund has 12 counterparties, with exposure ranging from 1% to 17% of NAV. For two of these it holds some collateral, but the majority of its exposure is uncollateralised, with total net exposure across all counterparties amounting to around 85% of NAV.

With iShares’ new range of CSI300 trackers, there are generally fewer counterparties with larger exposure to individual firms, but there is also more collateralisation, resulting in a net exposure of under 10% per counterparty. Nonetheless, you still end up with an overall uncollateralised counterparty exposure of around 35% on the CSI 300 benchmark tracker, for example.

Elsewhere, the two A share trackers run by Bank of China and Prudential’s joint venture each have three counterparties. At present, net combined exposure is around 16% for its SSE50 and 26% for its CSI300 fund.

CICC’s SZSE 100 tracker has three counterparties, with net exposure of 6-10% for each. Da Cheng’s new CSI China Mainland Consumer fund owns access products from Goldman Sachs, comprising 51% of the fund’s exposure, and from Merrill Lynch, making up 46%, although in both cases this is reduced to 8% by the provision of collateral. Ping An’s PAragon CSI RAFI 50 tracker, the first fundamentally weighted A share ETF, has Citigroup as its sole counterparty, with net exposure reduced to around 8% by collateralisation.

1 | 2 |