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Brokers move against synthetic ETFs

HSBC has removed synthetic exchange traded funds from its platform. What is behind the move?
August 6, 2015

The debate between choosing a physical or synthetic exchange traded fund (ETF) is long-running and now some brokers are making the decision for you, with HSBC Invest Direct taking all synthetic ETFs off its platform last month. Meanwhile, other investment platforms are increasingly designating synthetic products as complex products under new regulation. What does this mean for you and what can you buy from where?

Last month HSBC removed all synthetic ETFs from its broking platform, forcing all customers using its Invest Direct service to either sell out of or exchange their synthetic ETFs for physical products. The bank gave customers between 30 June 2014 and 30 June 2015 to make the change.

Synthetic ETFs use derivatives like swaps agreements in order to track an index rather than buying the securities in the index and holding them physically. They are often seen as less popular due to the fact they involve agreements with third parties, which some see as adding risk to the products.

Previously all UK listed ETFs were allowed on the platform but HSBC now only sells physical ETFs which physically hold the assets they track, saying: "If customers want to invest in the physical version of the same ETF they will need to sell out of the synthetic version and buy the physical version if it is available on our platform." Normally the platform would charge fees for dealing or transferring out but in these cases HSBC has waived those fees.

HSBC claims the move was made in order to "reflect our level of risk and customer demand" and it is not the only broker which does not sell synthetic ETFs to retail customers. Tilney Bestinvest also only offers physical ETFs.

In recent years, many brokers have re-labelled them as complex products under new European regulations governing the financial markets known as MiFID II. The complexity label means that a lot of synthetic ETFs will carry a higher regulatory burden for anyone selling them via platforms.

Non-complex products do not require providers to ensure that investors have financial advice prior to buying them whereas asset managers and brokers have to carry out an appropriateness test when selling complex products directly to the financial market.

Barclays Stockbrokers introduced an appropriateness test for not only its synthetic but also its physical ETFs two years ago for all retail clients. Anyone investing in ETFs for the first time is asked to complete an appropriateness test. They only need to do this once, and Barclays Stockbrokers records their completion on its systems and the next time they decide to invest in an ETF they will not be presented with ones deemed unsuitable.

In contrast, Tilney Bestinvest does not require an appropriateness test for physical ETFs but does designate synthetic ETFs as complex products, choosing not to offer those to retail clients on its platform. Jason Hollands, managing director at Tilney Bestinvest, says: "We don’t treat physical ETFs as complex products and these are available on our platform. We do however treat anything more exotic, including synthetic and leveraged ETFs, as complex and as such these are not available on our platform."

AJ Bell YouInvest offers both, with ETFs representing 10 per cent of total customer assets at the end of June 2015. However despite offering both, it is clear that customers are favouring physical replication, with just two of the top 50 ETFs by assets under management using synthetic or indirect replication, representing just 1.2 per cent of total customer assets held across the top 50.

Providers have also been edging away from synthetic replication in the retail market. Deutsche Bank transferred 30 of its synthetic ETFs to physical replication in 2014 and is continuing to roll out the project this year. Lyxor has been doing the same on the back of weakening consumer demand for synthetic products.

According to Barclays, just two of its most popular ETFs bought on the platform were synthetic with the rest made up of low-cost physically replicating ETFs.

 

Is physical better than synthetic?

Investors perceive synthetic ETFs as carrying a higher risk and being harder to understand than their physical counterparts but there are some benefits to synthetic ETFs, particularly when it comes to illiquid markets such as smaller companies or some emerging countries.

Because synthetic vehicles do not have to buy the securities themselves, it can be easier and cheaper for them to mimic an index tracking illiquid or niche markets than a physical product. Entering into swaps deals in order to earn the return of the index without having to own the index makes it easier to perform in this context.

It is also worth bearing in mind that physical ETFs can enter into agreements with third parties too and may loan out the securities they hold for a fee. When it comes to choosing what to go for, look at the market you are in as well as cost and availability.

 

Top ETFs sold through Barclays last week

iShares Core FTSE 100 UCITS ETF (Dist)ISFPhysical
ETFS FTSE 100 Leveraged (Daily 2x) GO UCITS ETFLUK2Synthetic
iShares UK Dividend UCITS ETFIUKDPhysical
iShares EURO STOXX 50 UCITS ETF (Dist)EUEPhysical
iShares FTSE 250 UCITS ETFMIDDPhysical
iShares S&P 500 UCITS ETF (Dist)IUSAPhysical
ETFS FTSE 100 Super Short Strategy (Daily 2x) GO UCITS ETFSUK2Synthetic
Vanguard FTSE 100 UCITS ETFVUKEPhysical
iShares EURO Dividend UCITS ETFIDVYPhysical
IShares MSCI Japan UCITS ETF (Dist)IJPNPhysical

Source: Barclays, week ending 24 July 2015