Synthetic ETF Boom Slows

In recent months global financial market regulators have expressed concern about the proliferation of synthetic exchange-traded funds. Some, such as the UK’s Financial Services Authority, now threaten to impose restrictions on the distribution of these swap-based ETFs. But an analysis of European fund launches suggests that the synthetic ETF boom may be slowing of its own accord.

According to BlackRock’s ETF research and implementation strategy team, this year, to the end of May, is the first year since 2005 in which the number of synthetic ETFs in Europe has grown at a slower pace than the number of physically replicated funds.

ETFs In Issue – Physical vs. Synthetic

Number of Funds	2005	2006	2007	2008	2009	2010	May 2011
Physical	138	184	231	252	314.0	385	418
Synthetic	27	89	192	383	515	683	733
% Growth YoY	2005	2006	2007	2008	2009	2010	May 2011
Physical	n/a	33%	26%	9%	25%	23%	9%
Synthetic	n/a	230%	116%	99%	34%	33%	7%

When measured by the number of European ETFs in existence, synthetic funds overtook their physical counterparts in 2008 and have been stretching their lead ever since. As at the end of May, there were 733 synthetic ETFs in existence in Europe, compared with 418 physically replicated ETFs. By contrast, in the European ETF market’s early days, most funds followed the traditional physical replication method that was pioneered in the US.

From the end of 2005 to the end of 2008 the number of synthetic ETFs in Europe enjoyed a more than fourteen-fold increase, from 27 to 383, while physical ETFs grew in number more slowly, from 138 to 252, over the same period. Over the five years ending in 2010 the compound annual growth rate in the number of European synthetic ETFs was 91 percent.

However, for the first five months of this year, the synthetic ETF total has grown by only 7 percent from the 2010 year-end value, a dramatic slowing in the rate of increase. Meanwhile, when measured in percentage terms, the rate of growth of physical funds in 2011 is exceeding that of synthetic ETFs for the first time since 2005.

Asset Growth – Physical vs. Synthetic ETFs

Assets, US$ Bn	2005	2006	2007	2008	2009	2010	May 2011
Physical	41.3	64.1	80.6	76.4	125.0	155.1	177.4
Synthetic	13.6	25.6	48.0	66.4	101.9	128.6	140.5
% Growth YoY	2005	2006	2007	2008	2009	2010	May 2011
Physical	n/a	55%	26%	-5%	64%	24%	14%
Synthetic	n/a	88%	88%	38%	53%	26%	9%

In terms of assets under management (AUM), physical ETFs still outweigh synthetic ones, by US$177 billion to US$141 billion at the end of May, according to BlackRock. The difference between physical ETFs’ predominance in the AUM figures, as opposed to the figures for the number of funds, reflects the influence of iShares, Europe’s largest issuer of ETFs, which had a 36 percent market share at the end of May. Most funds in iShares’ ETF range follow the physical replication route.

However, in the five-year period from 2006 to 2010, synthetic ETFs grew their assets, in aggregate, at a faster rate than those of physical funds in all years except 2009. But in the first five months of 2011 this trend has reversed: physical funds grew their assets by 14 percent, compared with only 9 percent for synthetic funds.

A slowing in the rate of expansion is also visible in the number of funds issued by Europe’s largest two synthetic ETF providers, Lyxor and db x-trackers, who rank second and third in a league table of ETF issuers by AUM (the two firms had US$53.7 billion and US$51.3 billion in assets, respectively, at the end of May).

While Lyxor and db x-trackers launched a combined total of 74 ETFs in 2008, 31 ETFs in 2009 and 75 ETFs last year, by the end of May this year, they had added only 13 new funds between them. Swap-based Amundi ETF, which launched 21 new ETFs in 2008, 39 in 2009 and 29 in 2010, has launched only seven new funds in the same five-month period, while Source, which launched 56 ETFs from the start of its operations in 2009 to the end of last year, has added only six funds in 2011.

And iShares and Credit Suisse, both of which launched swap-based ETFs in 2010 to complement their existing physical funds, have both failed to expand their synthetic fund ranges since.

Some smaller ETF issuers are filling the gap left by the bigger providers: both RBS and UBS have expanded their fund ranges this year with the issuance of new swap-based trackers. A new synthetic ETF provider, Ossiam, has also just joined the fray.

On the other hand, physical ETF launches are keeping pace with synthetic ones in 2011. State Street has added 11 new ETFs in the year to the end of May in a relaunch of its European fund range, and is said to be planning up to 50 more ETF launches. HSBC Asset Management has upped the pace of growth of its ETF range, with 10 new funds so far in 2011, the same as the number it added during the whole of last year. And the launch of a European physical ETF range by US giant Vanguard is said to be imminent, with up to 11 funds likely. All three of these issuers have said that they will stick to the physical replication route for the foreseeable future.

Whether the slowdown in the rate of growth of synthetic ETFs is the result of a natural maturing of the market, a by-product of the pressure on bank balance sheets and rumoured increases in the cost of providing derivatives, or an inevitable consequence of a recent barrage of risk warnings is unclear. But if regulators are worried about the proliferation of ETFs that use derivatives to track their indices and would like to cap the market’s growth, it appears that some of their work is being done for them.