Two of the largest exchange traded fund (ETF) providers have begun offering physical ETFs, marking a departure from their roots.
Until now, db X-trackers and Lyxor have offered synthetic ETFs only - these products track market indices using swaps and other derivatives. Both providers now plan to offer physical ETFs that buy the underlying constituents of the relevant index in order to track performance.
In September, Lyxor announced the launch of a physical ETF range by the end of 2012, starting with fixed-income index trackers. This month, db X-trackers announced it would launch six physical replication ETFs in December.
According to db X-trackers, the different types of replication can also be termed direct (physical) and indirect (synthetic). "Investors will be able to go to a single provider and chose not only the type of market exposure they want, but also the type of tracking method they feel most comfortable with," says Thorsten Michalik, global head of db X-Trackers. "Some client segments have shown a preference for direct replication and as a provider we aim to meet that demand."
Business models among some of the smaller players have already responded to this trend - Credit Suisse recently introduced physical ETFs alongside its synthetic offerings while UBS also provides synthetic and physical ETFs.
The ETF sector is, however, increasingly dominated by the market leader BlackRock's iShares, plus State Street Global Advisors and Vanguard, whose business models are driven by physical ETFs (iShares has offered synthetic ETFs in a few areas).
Synthetic ETFs came under regulatory scrutiny last year for the counterparty risks that they entail, with several European regulators voicing their concerns over possible systemic risks of swap-based products.
Several synthetic ETF providers responded by working hard to reassure investors on risk and transparency issues. Measures have included limiting exposure to swap counterparties, holding collateral to protect value for investors and disclosing counterparties and collateral holdings to investors.
Nevertheless, investors have been flocking into physical products. Flows into physically replicated ETFs have been consistently outpacing those into synthetics over the past year.
The reality is that it is easier for investors to understand how physical ETFs work. Despite the efforts made by providers of synthetic replication ETFs to improve the level of transparency and investor protection in their product line ups, investors remain wary of swap-based ETFs. The statement from db x-trackers says: "We appreciated that some investors may be more comfortable investing in products that do not use derivatives for primary portfolio management purposes".
However, physical vehicles face similar counterparty risks, particularly when they conduct securities lending, which many of them do in order to reduce the total expense ratio (TER) on the fund.
Another caveat is that few physical ETFs buy all the stocks in an index, especially if it's an index with hundreds of constituents. If a particular security is difficult to buy - for example, in an emerging market where access may be difficult for foreign investors - the manager may own some sort of proxy such as an American Depository Receipt (ADR) rather than the actual stock. This means the index could significantly outperform the ETF, as happened to the iShares MSCI Emerging Markets ETF over 2009. It returned 81.97 per cent, against 85.29 per cent for the index. The ETF was also held back in rising markets by holding cash during certain parts of the year to pay dividends.
Another thing to watch is cost and tracking error - synthetic ETF providers argue that their products are cheaper and more efficient than physical ETFs.
At Investors Chronicle, we see merits in both replication methods. For example, in last year's ETF awards, db x-trackers FTSE 100 ETF (XUKX) - a synthetic ETF that tracks the FTSE 100 index - won the category Best Exchange Traded Product for UK Equity Exposure. In contrast the iShares S&P 500 ETF (IUSA), a physically replicated product, won Best Exchange Traded Product for US Equity Exposure.
New db X-Trackers products
db X-trackers' new physical ETFs will track the Dax, Nikkei 225, S&P 500, FTSE 100, Euro Stoxx 50 and Euro Stoxx 50 ex-financials indices. db X-trackers' current indirect replication ETFs tracking the DAX, the S&P 500 the Euro Stoxx 50, the FTSE 100 and the MSCI Japan indices will remain unchanged. Initial roll-out of the new direct replication ETFs is scheduled for December and will continue into 2013. The direct replication products will include the identifier '(DR)' in their fund names.
The new direct replication ETF tracking the Euro Stoxx 50 will have a TER of 0.15 per cent, compared with the existing indirect replication Euro Stoxx 50 ETF that has a 0 per cent TER. For other ETFs, fees will be the same for the direct and indirect versions.
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