Investors in Europe withdrew $1.9 billion from synthetic (i.e., derivative-based) exchange-traded funds last month, according to Bloomberg (“Synthetic ETFs Lose $1.9B in Europe”). On the other hand, physically backed funds had inflows $3.11 billion.
The disparity was most conspicuous in Europe. “In Europe, the fortunes of physically backed and derivative-backed products have diverged over the last three months with investors showing a preference for funds and products that purchase the underlying assets,” Kevin Feldman, a managing director at New York-based BlackRock, was quoted as saying.
Synthetic exchange-traded funds purchase futures and total return swap contracts to generate their return. Physically backed exchange-traded funds purchase the actual stocks, bonds or commodities in the index they seek to track.
Derivatives contracts reduce the transparency of a fund’s pricing and holdings and increase risks of tracking errors and counterparty default. In addition, derivatives introduce complexities that most ordinary investors and or brokers do not fully understand. Experts say they produce nonlinear (kinked) outcomes and non-normal (skewed) distributions. To determine whether they are fairly priced, one would have to be able to do the Black-Sholes mathematical computations that earned a Nobel prize.
Synthetic exchange-traded funds are mostly sold in Europe, and comprise 40 percent of exchange-traded fund assets there. In the U.S., synthetic exchange-traded funds consist mostly of leveraged and inverse funds, and commodity-based funds.
Regulators have expressed concern that the risks are not understood by investors. The U.S. Securities and Exchange Commission suspended approvals for new synthetic exchange traded funds in March 2010. In June 2011, the U.K. Financial Services Authority expressed concerns about counterparty risk, and the quality and liquidity of collateral that derivatives providers give synthetic exchange-traded funds to protect them in the event of the counterparty’s bankruptcy. The International Monetary Fund and The Bank for International Settlements also have investigated whether synthetic exchange-traded funds would pose systemic risk in a market crisis.
Synthetic exchange-traded funds involve extreme risks that make them unsuitable for most investors.
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