How Risky Are Synthetic ETFs?

This is the fourth in a series of posts on ETFs with the first three focusing on potential liquidity problems in a financial crisis which was in response to a Noah Smith column, order completion in a rapidly down trending market, and difficulties of ETF market makers.

In 2012, Morningstar did an extensive global study of synthetic ETFs which is a good starting point to understanding the risks in synthetic ETFs. 

Synthetic ETFs do not track an index.  They use swaps with counter-party risk and/or futures contracts which are more difficult and expensive to manage.  They are usually commodities ETFs or
ETNs.  Some commodities ETFs are physical ETFs (not synthetic) which actually, physically hold the commodities.  With respect to physical commodities ETFs the question has always been what amount of the commodity do they actually hold, i.e., do they only have physically in hand a statistical amount which they calculate to be more than sufficient to satisfy daily redemptions or an amount equal to NAV and/or does the physical holding of the commodities amount to hoarding.and drive up prices. 

While the questions with respect to physical commodity ETFs have never been completely answered and they have the same risks as other ETFs in a rapidly down trending market with respect to their commodity prices, the issuance of synthetic ETFs, while prevalent -- and  while the problems have been widely acknowledged -- in Europe (here is a Morningstar 2017 study of the European ETF market place) and elsewhere, have been banned in the United States since 2010.  Only those which existed prior to 2010 are allowed to be traded in the United States.

While it is possible to buy and warehouse commodities such as metals (not all such ETFs are physical), it is impractical to do so with agricultural commodities such as corn, wheat, etc.  This means you need to know what the ETF actually holds and the associated risks.  Is it a physical or swap/futures synthetic ETF?  Does it hold a one commodity or a diversity of commodities?  If it holds futures contracts, what is the contango risk?

On August 10th, the Federal Reserve published a Fed Notes "Synthetic ETFs" which detailed the structure and composition of synthetic ETFs, the types, a sample study of synthetic ETFs (there are 899 worldwide and they compose about 20% of the European market), the collateralization of synthetic ETFs and the risks of asset manager and counter-party affiliation, and concludes

"Synthetic ETFs are riskier structures than physical ETFs because investors are exposed to counterparty risk. They are mostly domiciled in Europe, where they represent about 20% of total ETF assets. Slightly more than half of non-US synthetic ETFs, by assets, voluntarily provide details about their collateral baskets. These ETFs are overcollateralized by 2%, on average, and they mostly have an unfunded swap structure, which provides the asset manager with direct ownership of the collateral.  Collateralization tends to decline slightly when financial markets are more volatile, especially if the ETF manager is affiliated with the swap counterparty.

"It is unclear whether our findings on collateralization levels also apply to synthetic ETFs that do not report collateral details, which continue to remain opaque investment vehicles."

The bottom line is synthetic ETFs are far more risky than ETFs and mutual funds which have physical assets.  

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