Dave Shastri, Chief Strategist at Truss Edge, writes that synthetic ETFs are ETFs that rely on underlying derivatives and swaps to gain their market exposure.
They do not hold underlying securities like a physically replicated ETF. The funds typically function using counterparties in the market. Some investors feel they do a better job of tracking an index, especially where benchmarks are less liquid. They also offer access to non-equity markets like commodities. However, synthetic ETFs do introduce the risk of the ISDA counterparty so are not employed for all types of funds.
Synthetic ETFs are an important part of the overall market, having first been launched in 2001. They remain very popular in the European market and are increasingly important in Asia as well. An estimated 1000 ETFs are currently synthetic, accounting for approximately 11 per cent of the entire ETF universe. The growth in certain active investment strategies being implemented as ETFs requires the use of synthetics.
Why are synthetic ETFs hard to support?
Synthetic ETFs are tougher to support if a fund manager is relying on technology that is usually employed to support physical share portfolios. There are very few technology solutions that can currently manage both.
This is partly because there are two types of synthetic ETFs – funded and unfunded. They require the use of counterparties and swaps to achieve their replication, and do not necessarily use the same basket of stocks as the index they are trying to replicate.
Can white label platforms support synthetic ETFs?
We are seeing more white label platforms coming onto the market, offering regulatory and distribution support for ETFs. However, synthetic ETFs can pose a taller order for the promoter of white label solutions.
Operationally speaking, fund managers and third-party platforms supporting synthetic ETFs need to see live data around collateral calls – e.g. current collateral cash on hand vs the valuation of synthetic swap holdings. Actions taken by the portfolio management team are hard to view on a live basis, but this is now achievable.
Why UCITS present an additional challenge for synthetic ETFs
Effective reporting is also needed around issues that regularly crop up with ETFs, like cash on hand breaches. This is essential for fund managers and platforms that are supporting the regulatory needs of UCITS funds in Europe, for example, where there is a need to calculate daily repo / non-cash vehicle prices. Different vehicles need to be treated according to whether they line up as cash or collateral.
It can be difficult for some industry systems to manage the dealing activity and related cash flows for ETFs on both synthetic and physical funds on the same report. Fund managers are also now starting to ask for live risk reporting and ETF monitoring tools (e.g. tracking error, portfolio analysis and holdings mismatch). This is difficult functionality to build in-house.
Cash management within ETFs is a subject unto itself, but sophisticated white label platforms should be able to offer cash integration into one platform, including using a multi-custodian model where required. This kind of multi-lateral functionality is especially important for synthetic ETFs, where swap counterparties and the collateral desks at custodian banks need to be circled in. This frequently needs to be supported by internal calculations to ensure that client funds do not breach UCITS rules. It’s most efficient if these calculations are not offline but are incorporated into the portfolio management platform.
Overall, the growth in the synthetic ETF market is providing challenges for ETF fund back offices, especially where they need to collate multiple data flows in real time and manage breaches and cash effectively under UCITS restrictions. Technology can play a big part of supporting sophisticated, efficient operations, including those with dozens of such ETFs on their books like white label platforms and larger management companies.
Dave Shastri is Chief Strategist at Truss Edge, a technology platform that supports the daily operational needs of ETF managers and their service providers.