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SFO scrutiny for synthetic complexities

Joanne Ellul reports on growing concerns over swap-based exchange traded funds

Exchange traded funds have recently caught the head-lines, with the FSA and the Serious Fraud Office raising concerns about the increasing risks posed by the products as they grow in complexity.

Last week, the SFO launched a review into how ETFs are marketed and whether it has the capability to prosecute any wrongdoing in the industry. At the end of June, FSA chief executive Hector Sants questioned the funds’ appropriateness for all investors, saying: “There are question marks over whether synthetic ETFs really are appropriate for all types of the retail marketplace.”

This follows a warning from the Financial Stability Board in April, which said the structure of synthetic ETFs could be an issue. It claimed the firm holding the swap counterparty risk is usually acting as the ETF provider and that a default at the banks active in swap-based ETFs may act as “a powerful source of cont-agion and systemic risk”.

In response to the neg-ative press, Evercore Pan-Asset Capital Management has decided it will stop using swap-based ETFs in the majority of its range.

The boutique had a 10-20 per cent weighting in swap-based ETFs in five out of six model portfolios and in its three open-ended funds. Only its higher-risk aggressive model portfolio and Oeic will now contain swap-based ETFs and it has moved £200m from other funds into physical ETFs.

Evercore chief executive Christopher Aldous says: “We did this because we cannot explain the detail to people who we do not have any connection with. The IFA does not want to have that discussion because of the complexity.”

He says Sants has a legitimate concern about the billions of pounds going into swap-based ETFs and the underlying risk is there will be a mismatch between the location of assets and liabilities.

HSBC head of ETFs Farley Thomas also has concerns about synthetic ETFs. He says: “Given the questions surrounding ETFs, it would be prudent for us not to enter the market. Swap-based ETFs are not going to be understood by invest-ors, as even people in the industry have difficulty understanding them.”

According to figures published by BlackRock in May, 64 per cent of Euro-pean ETFs – 733 out of 1,142 – are synthetic but only 44 per cent of the assets under management by European ETFs – $141bn out of $318bn- are swap-based.

Thomas applauds the regulator in Hong Kong, which requires ETFs that use derivatives to have a market in their name. The Securities and Exchange Commission in the US has stopped approving such ETFs.

He says: “It would be a good start for the UK to have such an identification system. ETFs are Ucits-compliant, so it may imply that Ucits need to change.”

But iShares EMEA marketing director David Bower says synthetic ETFs have their uses. Two of iShares’ 104 ETFs listed on the LSE are swap-based, their Russia and India ETFs, and both are labelled as such.

Bower says this structure gives “exposure where it is difficult to access markets because of foreign exch-ange restrictions”. He says they have multiple coun-terparty risk rather than a single-party risk model.

He says the firm plans to expand its swap-based ETF range to access such difficult to reach markets.

Bestinvest senior analyst Ben Seager Scott says: “Swap-based ETFs track the indices more closely, usually by 1 per cent, but small differences add up over time. I am only comfortable with swap-based ETFs that are over-collaterised.”

He adds he does not believe swap-based ETFs should be labelled as such. “Physical ETFs may use representative sampling, where the difficulty to replicate the whole index means they only replicate part of it.”


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