Despite the recent regulatory criticism and the marketing efforts of some ETF issuers, the distinction between physical and synthetic ETFs is largely irrelevant, according to a new academic report.
In a paper released today, the Edhec-Risk Institute said all ETFs, not just those using derivatives, are exposed to counterparty risks and putting too fine a point on the benefits of physical replication conveyed a false sense of “comparative” safety.
“Securities lending is widely practiced by physical replication ETFs and leads to counterparty risk, just as surely as the reliance on over-the-counter derivatives by synthetic replication ETFs,” said the authors of a position paper entitled What are the Risks of European ETFs?
Synthetic funds bore the brunt of regulatory criticism last year, and investors took heed of the warnings by moving increasingly away from such funds in favour of those using physical replication.
However, Edhec said investors should “pay more attention to first-order issues that determine the effective mitigation of counterparty risk: the level of collateralisation, the quality of the assets performing the economic role of collateral and the ability of the fund to enforce its rights against collateral in the case of default by the counterparty”.
The academic institution, which specialises in the area of risk in asset management, also suggested that ETFs had attracted an unwarranted amount of negative attention considering the fact that most were operating as UCITS funds. “Highlighting the supposed risks of ETFs therefore makes little sense, and even less so in matters of retail investor protection in that ETFs represent but a fraction of the products sold to the general public in Europe and competing investment vehicles typically do not benefit from the same level of protection as that provided by the UCITS framework,” it said.
Ahead of new ETF guidelines expected to be released by the European Securities and Markets Authority over the coming weeks, Edhec recommended that regulators should introduce guidelines on tracking error, as well as instituting “a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes”.
In addition to increasing transparency on counterparty risks, Edhec also suggested issuers should provide investors with more information on the revenues and costs associated with ancillary activities such as securities lending.