Safehavens for the sophisticated risk investor

by Carmen Lee and Lim Siyi

How they work, the benefits and risks involved and how they will fare in the weak economic outlook
“ETFs provides the sophisticated investor with higher risk profiles with more liquidity, leverage and higher risk takings without holding on to the underlying stocks or commodities. – Contributed by Oogle.”

Equities have experienced a highly volatile session this year. In August alone, the Straits Times Index fluctuated about 17 per cent from a month’s high of 3,227 to a month’s low of 2,681.

This volatility was a result of the uncertainty in the global environment where several prominent themes continued to drag down market sentiment, including the slowdown in the United States and the euro zone. The dimmed investment outlook has led to an outflow of funds out of Asian equities with most countries experiencing a net outflow of funds this year, including in Singapore.

With the muted outlook ahead and the widely anticipated lacklustre performance of global equities this year, are exchange traded funds (ETFs) likely to offer a similar or different outcome?

ETFs are open-end index funds and can be traded like stocks on most exchanges. ETFs gained popularity in the last few years as they allow investors to gain exposure to different markets, commodities and sectors. According to Blackrock, the size of the market has grown rapidly from around US$105 billion (S$136.1 billion) in 2001 to more than US$1.4 trillion in July.

In Singapore, there are 84 listed ETFs. Of these, the iShares MSCI India and SPDR Gold Shares are the most actively-traded ETFs. The former offers an exposure to the India market and the latter as the name suggested offers an exposure to gold. These instruments are popular proxies to both, given the restrictive nature of investments in India and the relatively high cost of owning physical gold.

Recently, there has been increasing attention on synthetic ETFs, especially in view of the more complicated structures of these instruments and the key features and risks.

How synthetic ETFs work

Synthetic ETFs involve the use of derivative instruments, that is, swap contracts where the benchmark index returns are obtained in exchange for either cash payments or the returns of a separate basket of stocks bought by the manager. The ETF provider obtains cash investments/subscriptions from investors in the primary market and uses the cash to pay the swap counterparty on a subscription basis, in exchange for the returns of a designated benchmark index. The ETF provider then issues ETF shares to the investor in proportion to their investment amount.

To mitigate counterparty risk and to minimise it to a pre-determined level for example, 10 per cent of net asset value, the swap counterparty has to post collateral that is pledged to the ETF. In the event of a default, the collateral is protected as it is ring-fenced away from the swap counterparty’s creditor claims. The ETF will then claim the collateral and use it to reimburse investors.

Another scenario is one where the ETF manager purchases a separate basket of securities in the open market and exchanges its returns for the returns of the designated benchmark index. The basket of securities bought by the ETF is agreed upon under a set of “Investment Restrictions” listed in the prospectus so investors will know what type of investable instruments are acceptable.

Benefits of synthetic ETFs

Most European ETFs employ the use of synthetic replication and will use either scenarios described above. The biggest benefit is its “zero” tracking error (less fees and expenses) since the index returns are promised by the swap counterparty. It also allows access to a wide range of securities that are difficult to trade, and ETFs using these methods are easy to develop and to bring to markets.

Risks of synthetic ETFs

As the index returns are contingent on the swap counterparty fulfilling its obligation, the ETF is subject to counterparty risk. To mitigate these concerns, there are mechanisms in place to protect ETF investors from events of counterparty defaults.

While these mechanisms help to protect ETF investors in the event of a single counterparty default, there still exists a possibility, although remote, that several counterparties, such as investment banks, could fail at the same time. Should this worst-case scenario occur, it may potentially pose serious contagion and systemic risk to the financial markets, beyond ETFs.

In such an event, the collateral pledged by these counterparties will be seized by the Trustee to protect the ETF. However, its investors may still be susceptible to losses, especially if the values of the collateral decrease as a result of broad market sell-off reactions to these bank defaults. ETFs are ultimately participants in the broader market, and while ETF collateral management has evolved to mitigate risks, no plan is without flaws and ETF investors could potentially lose their entire investment value.

Understanding the risks involved is key

Synthetic replication may have its flaws but investors should not focus solely on the negative aspects and worst-case scenarios. Instead, they should explore, educate themselves and understand the swap-based ETF structure as well as the safety nets in place before determining if such an investment vehicle is suitable for them and their risk-tolerance levels.

A plus point from the recent criticism is that it has encouraged ETF providers to be more forthcoming with their index tracking methodologies and risk management procedures. Current guidelines like that of UCITS are aimed at providing a high and consistent standard for ETF issuers to adhere to, and advertently push them to even higher levels of disclosure and transparency.

Given the complexity and risks involved with ETFs investment, we advise investors to fully understand the investment methodology, risk management policies and benefits of ETFs before investing in these products.

Carmen Lee is the head of OCBC Investment Research and a member of the OCBC Wealth Panel. Lim Siyi is an investment analyst at OCBC Investment Research.