HSBC Gets Physical

Amid the heated war of words over the structural risks of ETFs, a new fund offers investors the chance to compare the synthetic and physical replication approaches in what has traditionally been one of the more difficult areas of the market for tracker funds to access.

HSBC this week launched the first ETF in Western Europe to offer physical tracking of Russian equities (Russian brokerage Troika Dialog issued an ETF investing in domestic shares last year).

HSBC’s sales pitch alluded to risks in competing synthetic ETFs. “By putting together a physical Russian equity ETF, we are responding to investors’ concerns with respect to complex ETFs and demonstrating our commitment to delivering products that are as transparent and simple as possible,” said Farley Thomas, the bank’s head of ETFs.

So why isn’t the ETF market’s foremost exponent of physical replication—iShares—competing with HSBC in what might seem its natural habitat?

iShares did launch an ETF tracking exactly the same index as HSBC’s new fund—the MSCI Russia capped—last September. But it chose to use swaps to achieve its objective, rather than buying the underlying index shares. Credit Suisse also opted for the synthetic route last August when it launched a new range of emerging markets trackers.

“iShares has always recognised the value of swap-based structures in providing access to markets where the assets are either difficult to hold in a physical form or where UCITS III compliance may be difficult due to index-related issues,” the ETF market’s largest issuer states on its European website.

When I met with the firm’s head of product strategy, Feargal Dempsey, yesterday, he was at pains to clarify that iShares did not want to be seen as rejecting synthetic replication as a tracking methodology. iShares is considering further fund launches of this type in Europe, he said.

It’s worth remembering that the highly publicised tracking problems experienced in 2009 by iShares’ flagship US-listed MSCI Emerging Markets ETF, EEM, which uses physical tracking, were due in significant measure to Russia and to the highly divergent performance of domestic—Russia-listed—and “offshore” (ADR and GDR) versions of Russian shares in the MSCI index.

The global depositary receipt (GDR) of Russia’s main savings bank, Sberbank, for example, traded at a 130 percent premium to the Russia-listed version of the bank’s shares early in 2009. The premium fell to zero by the end of the year, severely affecting the performance of those funds (like EEM) that held GDRs rather than the domestic shares used in the index calculation.

For its part, HSBC is well positioned to pursue the physical replication route in emerging markets due to the bank’s extensive global network of sub-custodians (although in Russia, it is outsourcing this role to ING). For other issuers of ETFs tracking Russian share indices, it’s obviously still preferable to outsource the problem of replication to those investment banks that specialise in Russian share trading. Outsourcing the index replication via swaps means that a problem such as that created by Sberbank in 2009 becomes one for the swap counterparty, rather than for the ETF issuer.

All these considerations go to show how nuanced the debate is when it comes to competing ETF methodologies. It certainly won’t be easy for regulators to draw a dividing line if they are really considering restricting access to certain types of funds.

And while Russia may stand out as a test case for the synthetic/physical debate, investors shouldn’t lose sight of the fact that there are weightier risks to face when they consider sending their hard-earned cash eastwards.

“The concept of fiduciary duty on the part of a company’s management is generally non-existent. Local laws and regulations may not prohibit or restrict a company’s management from materially changing the company’s structure without shareholder consent. Foreign investors cannot be guaranteed redress in a court of law for breach of local laws, regulations or contracts. Regulations governing securities investment may not exist or may be applied in an arbitrary and inconsistent manner,” says the prospectus for the HSBC MSCI Russia Capped ETF.

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