Problems at Deutsche Bank have been worrying exchange traded fund (ETF) investors - even if they don't hold ETFs that track the shares of banks. That is because the bank's financial problems have resurrected concerns over synthetically replicating ETFs, which rely on Deutsche Bank as the swap counterparty for their returns - even if the indices they track have nothing to do with banks.
Deutsche Asset Management has 58 synthetic ETFs listed on the London Stock Exchange for which Deutsche Bank is the swap counterparty, although it has been reducing that number over recent months. Unlike physically replicating ETFs, which hold the assets in the indices they track, synthetically replicating ETFs enter into swap agreements with a counterparty that agrees to pay the return of the index tracked. Under the most common synthetic structure, known as an unfunded swap, the ETF holds instead a substitute basket of assets and pays the counterparty the return of those in exchange.
Investors are worried that the ETFs for which Deutsche Bank is the swap counterparty could be at risk if the bank is forced to pay a $14bn (£11bn) fine which has been levied by the US Department of Justice for the sale of certain mortgage-backed securities before the financial crisis. Deutsche Bank acts as counterparty to a wide number of banks and deals, including all of its synthetic ETFs. Examples of such ETFs include db x-trackers Barclays Global Aggregate Bond UCITS ETF (XBAG), db x-trackers CSI 300 UCITS ETF (XCHA) and db x-trackers MSCI EM Asia Index UCITS ETF (XMAS).
Should you be concerned?
Investors need not panic - Deutsche Bank's synthetic ETFs generally hold collateral or a substitute basket of assets worth at least 100 per cent of their net asset value (NAV), which could be sold if Deutsche Bank failed to meet its obligations as swap counterparty. According to a Morningstar report, the bank's practices are "within the industry norm" and go beyond Undertakings for the Collective Investment of Transferable Securities (UCITS) requirements regulating counterparty risk.
UCITS rules demand that ETF counterparty risk is limited to 10 per cent of the value of the fund's NAV, meaning that in the worst-case scenario 10 per cent is the most that would be wiped off the ETF's value. But most of Deutsche Bank's ETFs are 100 per cent collateralised or over collateralised.
Deutsche Bank is not the only provider offering synthetic ETFs. According to data provider FE Trustnet, there are 372 physically replicating ETFs domiciled in Luxembourg, the UK and Ireland out of a total 967 domiciled in those areas, and other providers offering them include Lyxor and Source.
There is nothing intrinsically wrong with synthetic ETFs and in some cases they are the best way to track an index. But it is still important to be aware of their risks, such as the swap counterparty. "You need to be sure that you understand the collateralisation policy and the set-up of the ETF," says Ben Seager-Scott, director of investment strategy and research at Tilney Bestinvest.
Investors in synthetic ETFs need to understand what assets the ETF actually holds, as they would take ownership of them in the case of the swap counter party defaulting. Those assets could be very different to the assets in the index the ETF tracks.
For example, db x-trackers Barclays Global Aggregate Bond UCITS ETF holds 99 per cent of the value of its NAV in a substitute basket. That basket, 44.64 per cent of which is government bonds and 17.99 per cent of which is corporate bonds, looks fairly similar to the Barclays Global Aggregate Bond Index this ETF tracks, and is likely to perform in a similar way to this index. If Deutsche Bank defaulted on its obligation to pay the return of this index to the ETF, the ETF would sell that basket to redeem investors.
However, db x-trackers CSI 300 UCITS ETF's basket of assets, which is worth 104.52 per cent of its NAV, is made up of Japanese, German and US equities - as well as the Chinese equities in the CSI 300 index the ETF tracks .
That may appear surprising but there is a good reason - liquidity. In the case of a collateral or substitute basket, the purpose of the assets is to be sold quickly to redeem investors' money. Equities from narrow or illiquid markets such as China are unlikely to be a good solution for this, so more commonly traded blue-chip US equities are a better option.
However, Mr Seager-Scott says there could be times when holding a basket of substitute stocks that differ wildly from the assets you track could be a negative. "In a crisis, if your ETF is broadly holding a basket of the same things as the index you track, then you almost have a physical ETF," he says. "However, it could be more problematic if equities are being held as collateral for bonds, or something similar, because when things go sour, the chance of your collateral moving in the opposite way to the index is higher, and could be a problem."
If you are considering investing in a synthetic ETF, the first thing to check is the counterparty agreement. Deutsche Bank is moving towards having multiple counterparties on many of its synthetic ETFs, which means the risk of default is spread among more third parties.
Mr Seager-Scott says the next things to check are whether your ETF employs a fully funded swap model, whereby the ETF pays a counterparty for the return of an index and has access to collateral held by a third party in event of a crisis, or an unfunded swap. Under the latter model, the ETF holds a substitute basket of assets which it can sell in event of a crisis. In each case, investors can see the assets held as collateral or a substitute basket on the ETF's website.
|Unfunded vs funded ETFs
Unfunded synthetic ETFs hold a substitute basket of assets and swap the returns of those assets for the performance of the index they track. In the case of counterparty default, the ETF sells the substitute basket to redeem investors.
Fully funded synthetic ETFs pay a counterparty to deliver the return of the index and in return the counterparty posts collateral with a third-party custodian. This is sold in the case of counterparty default.
"First, see who the counterparties are - multi-counterparty agreements are preferable," says Mr Seager-Scott. "Then see if it is over-collateralised as well as what assets are being held in the substitute basket or as collateral, and consider as to whether you are happy with this."
Lyxor and Source also offer synthetic ETFs backed by single counterparties, and with the Lyxor funds its owner French bank Societe Generale tends to take that role.
Bear in mind, too, that synthetic ETFs can accrue swap fees, which could bump up the price of the ETF.
Synthetic ETF benefits
There are many valid reasons why an ETF might use a swap structure. Commodity ETFs can only be structured as synthetic products because they cannot store large quantities of, for example, oil and so hold derivatives contracts based on commodities instead.
The same is true for short and leveraged ETFs that cannot physically replicate.
Synthetic ETFs are also useful in highly illiquid markets, where it can be very difficult to trade assets. In these cases, synthetic ETFs tend to have much lower tracking difference as a counterparty is delivering the exact return of the index without having to buy and sell the illiquid assets.
"In these situations you are swapping liquidity risk for counterparty risk," says Mr Seager-Scott.
It's not only synthetic ETFs that are exposed to counterparty risk. Physical ETFs are exposed to this when they engage in securities lending. This is when a physical ETF lends the stocks it holds for a fee, in return for collateral. In this case, the risks are similar to a synthetic ETF.
But, despite some benefits, private investors have been favouring physical ETFs, so providers have been converting their synthetic funds to physical ones.
Deutche Asset Management has converted over 40 db x-trackers ETFs from synthetic to physical replication over the past three years, in particular during the last few months. In March 2016 Deutche Asset Management announced it would begin converting its fixed income ETFs from synthetic to physical replication, including db x-trackers II Eurozone Government Bond UCITS ETF (XGLE) and db x-trackers II iBoxx $ Treasuries Inflation-Linked UCITS ETF (XUIT).
And Lyxor converted its flagship Euro Stoxx 50 UCITS ETF (MSED) into a physically tracking equivalent in November 2015.
Among brokers, meanwhile, earlier this year HSBC Invest Direct removed all synthetic ETFs from its platform, in a move it said reflected customers desire for simpler products. And broker bestinvest.co.uk only sells physical ETFs.
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