Synthetic Exchange Traded Funds (ETFs)

While all ETFs seek to achieve the same return as a particular market index or benchmark, there are generally two common ways for an ETF to track the performance of the relevant index or benchmark.

Conventional

Conventional ETFs seek to achieve the same return as a particular market index or benchmark. This type of ETF is similar to an index fund in that it will primarily invest in the securities of companies or other assets that are included in a selected market index or benchmark. An ETF will invest in either all of the securities or a representative sample of the securities included in an index or benchmark.

Synthetic

Synthetic ETFs do not necessarily invest in the securities included in an index or benchmark (unlike conventional ETFs), but rather they aim to replicate the performance of the index or benchmark synthetically. They do this by holding financial instruments like swap agreements or futures contracts (collectively 'derivatives') to simulate the investment performance of the index or benchmark for the whole fund. The derivatives will require the ETF to pay or entitle it to receive payments so that return to the fund (before fees) reflects the performance of the index or benchmark not the assets actually held. Apart from any money owing from the derivative counterparty, the remainder of the fund's value is generally invested in other assets, which may or may not reflect the index or benchmark because the performance of the assets will impact on the derivative counterparty not the performance of the ETF.

You can identify synthetic ETFs by looking at the ETF name, synthetic will appear in its name.

Increased Risks

Synthetic ETFs are not the same as conventional ETFs because synthetic ETFs result in different risks for investors. You should always read the associated product disclosure statement carefully to ensure you understand how the relevant synthetic ETF operates.

Because synthetic ETFs use derivatives to achieve their investment objective, if you invest in these ETFs you are subject to the risk that the counterparty to the derivative will fail to meet some or all of their obligations to the ETF. This risk only applies to the portion of the ETF's assets that represents money owing to the ETF under the derivatives.  This risk is greater when the synthetic ETF uses over the counter (OTC) derivatives which are not subject to central counterparty clearing arrangements. Typically most synthetic ETFs use OTC swap contracts that are not subject to central counterparty clearing.

To assist in mitigating this risk, ASX requires that each synthetic ETF be operated to keep the amount of assets reflecting money owing by OTC derivative counterparties to a limit of up to 10% of the net asset value of the ETF. If for some reason the counterparty fails to meet its obligations to the ETF, the fund may not be able to deliver its return objective and investors could lose up to 10% or more of the value of their investment in the ETF.

The ASX has imposed restrictions on which counterparties ETFs can enter into OTC derivatives with, to try and minimise the risk of the counterparty failing to perform. 

There is also a risk that the level of derivative exposure within a synthetic ETF could temporarily exceed the 10% limit. If this happens, the ETF issuer would need to take prompt action to ensure the exposure is quickly reduced back to 10% or less but this may not always be possible.

For further information on the risks of holding synthetic ETFs refer to the ‘risks’ and ‘product comparison’ sections below.

How do Synthetic ETFs work?

When units in a synthetic ETF are created, capital is raised to purchase a basket of assets (usually financial instruments such as securities) to be used as collateral. Although usually the assets used as collateral securities will be in line with the investment objective of the fund, they may or may not replicate the index or benchmark being tracked. ETF units are created and dissolved as needed to meet market demand.

As the fund does not necessarily own the securities from the index that it’s aiming to replicate, it aims to achieve the index performance by entering into derivatives.

In addition there may be different taxation outcomes for investors in synthetic ETFs when compared to conventional ETFs, depending on whether any gains or losses in the ETF are achieved through holding the assets that make up the index or are achieved through the derivative exposure.

Risks of Holding Synthetic ETFs

The use of derivatives by synthetic ETFs to achieve their investment objectives results in different risks to investors when compared to investing in conventional ETFs.

The main difference is that because up to 10% of the fund (or sometimes more) is represented by money owing under the derivatives, investors are exposed to counterparty risk for this portion of the investment, i.e. the risk that the counterparty to the derivative will not fulfil their obligations.

If for some reason the counterparty fails to meet its obligations to the ETF, the fund may not be able to deliver its return objective and investors could lose up to 10% or more of the value of their investment in the ETF.

To limit counterparty risk, ETF Issuers put measures in place to mitigate and limit the swap exposure reaching an undesirably high portion of the ETFs total value.

Furthermore, ASX also imposes certain requirements on issuers of synthetic-based ETFs in Australia.

First, ASX restricts aggregate money owing under derivatives (i.e. counterparty exposure) to a maximum 10% of the ETF’s net asset value (NAV). If the derivative counterparty exposure of a synthetic ETF rises above 10% of the ETF's NAV, the issuer will be required to take prompt action to reduce the derivative counterparty exposure although such action might not always be immediately effective. Investors should check each fund’s product disclosure statement as there is no standardised approach to how this counterparty risk is monitored and managed. The higher the derivative counterparty exposure level, the larger the proportion of the ETF’s value exposed to counterparty risk.

ASX has also mandated that all derivative counterparties for synthetic ETFs on ASX must meet certain eligibility requirements.  Specifically, permissible counterparties are limited to: Bank ADIs (i.e., institutions that are granted an authority to carry on a banking business in Australia under the Banking Act 1959);  Foreign Banks authorised under the Banking Act 1959 or a foreign entity subject to an equivalent form of prudential regulation to the Banking Act 1959; or an entity unconditionally and irrevocably guaranteed by any of the preceding institutions.

Other risks of trading synthetic ETFs include:

  • Use of derivatives and counterparty risk - synthetic ETFs generally use over the counter (OTC) derivatives, which are not subject to central counterparty clearing arrangements.  Central counterparty clearing arrangements, where available, help to mitigate counterparty risk.
  • Taxation outcomes - there may be different taxation outcomes for investors in synthetic ETFs when compared with conventional ETFs, depending on whether any gains or losses in the ETF are achieved through holding the assets that make up the index or are achieved through the derivative exposure.  Any different taxation outcomes may significantly impact the effective return for investors in synthetic ETF
  • Exchange rate fluctuations - synthetic ETFs which seek to achieve the same return as a particular overseas market index or benchmark, and are traded and settled on ASX in Australian dollars, may be exposed to additional risks. If the ETF is not hedged against currency risk, fluctuations in the exchange rate can affect the value of the portfolio. Additionally, there may be political risks in the home country of the overseas market index or benchmark which can also affect the value of the portfolio.
  • Market risk - market conditions (for example, lack of liquidity) may make it difficult to buy or sell synthetic ETFs in certain circumstances

Product Comparison

Product Feature Conventional ETFs Synthetic ETFs
ASX traded   Yes Yes
Structure (generally) Registered managed investment scheme Registered managed investment scheme
Almost exclusively invests in securities included in the index or benchmark Yes May not hold all of the securities included in the relevant index
Underlying holdings

Equities (or other securities, all of which are in the relevant index or benchmark) and cash

Equities (or other securities, all of which may not be in the relevant index or benchmark), cash and index swaps
Product uses derivatives, swaps and/or futures to achieve returns Generally no, although may be used incidentally Yes
Derivative Counterparty risk No Yes (limited to 10% of the ETF’s NAV)

Things to Consider Before Investing

As with other products, it is important to read the product disclosure statement for synthetic ETFs to gain an understanding about an ETF's  investment objectives, principal investment strategies, risks, and costs. You should do this before you make a decision to invest or not. You can find the product disclosure statement on the website of the ETF issuer.

You should also consider seeking the advice of an investment advisor who holds an Australian financial services (AFS) licence or is a representative of an AFS licensee. Be sure to work with someone who understands your investment objectives and tolerance for risk. Your investment advisor should understand these products, be able to explain whether or how they fit with your objectives, and be willing to monitor your investment alongside you.  The ASX find a broker service may assist you in locating an investment advisor in your area.

Market Making

Market Makers provide an important role in ensuring that buyers and sellers of ETFs and ETCs can transact. They provide liquidity to the market by providing quotes through the trading day and update their prices to reflect changes in the underlying securities.

ASX offers a Market Making incentive scheme to further promote tighter spreads and more liquidity in the ETF (Exchange Traded Funds) and ETC (Exchange Traded Commodity) markets. Market Making Participants receive Trading and Clearing Fee incentives from ASX when achieving minimum quoting benchmarks on a monthly basis. Each ETF / ETC is assigned a spread and liquidity requirement.

The table found in the following PDF (82KB) shows the Market Makers (MM) that have signed incentive contracts with ASX and the relevant ETF/ETCs.