Synthetic Exchange-traded Funds Research Articles

The Tracking Efficiency of Physical and Synthetic Equity Index ETFs

This article evaluates the tracking efficiency of physical and synthetic Exchange Traded Funds (ETFs). Theoretically, synthetic ETFs should provide greater tracking efficiency. We study this using ETFs domiciled in Europe tracking the European, United States and Emerging Markets. We calculate the tracking error differences and use univariate analysis across both replication and regional strategies. Our contribution is in identifying the variables that influence ETF tracking efficiency. We find the total expense ratio remains the pre-eminent explanatory variable, but the type of replication strategy is a significant secondary factor. We observe that the counterparty risk in synthetic strategies is not rewarded relative to physical replication strategies, but the synthetic ETFs increase returns of tangency portfolios compared to physical ETFs when analyzed using mean-variance spanning techniques. This suggests investment in synthetic strategies is suited to risk tolerant investors and investment in physical strategies is more suited for risk averse investors. TOPICS:Exchange-traded funds and applications, analysis of individual factors/risk premia, VAR and use of alternative risk measures of trading risk, risk management, interest-rate and currency swaps Key Findings • The type of replication strategy employed by an ETF is a significant secondary factor in its tracking efficiency. • Synthetic ETFs’ replication increases returns of tangency portfolios compared to physical ETFs when analyzed using mean-variance spanning techniques. • Investment in synthetic strategies is suited to risk tolerant investors, while investment in physical strategies is more suited for risk averse investors.

Synthetic ETFs

Exchange traded funds (ETFs) achieve their investment objectives by either owning a portfolio of securities (physical ETFs) or entering into swap agreements that deliver the returns of pre-specified indexes (synthetic ETFs). In this note, we provide an overview of how synthetic ETFs work and analyze collateralization levels for a group of synthetic ETFs that voluntarily report their collateral baskets.

Physical and Synthetic Exchange-Traded Funds: The Good, the Bad, or the Ugly?

This article focuses on the replication process of exchange-traded funds (ETFs). It compares the tracking ability of ETFs based on physical replication of their benchmark indexes to those of synthetic ETFs. Synthetic ETFs rely on derivatives such as swaps. For ETFs listed at the Frankfurt Stock Exchange, we show that both categories of ETFs suffer from high tracking errors. Contrary to conventional wisdom, synthetic equity ETFs are not different in terms of tracking errors from their physical counterparts. However, synthetic fixed-income ETFs have lower tracking errors than physical fixed-income ETFs. Thus, synthetic ETFs have as good or better tracking errors than physical ETFs. We identify different factors influencing tracking errors.

Tracking Errors and Their Determinants: Evidence from Hong Kong Exchange Traded Funds

This paper extends the author’s previous study on the magnitude of tracking error, which used panel data to find the determinants of tracking errors in exchange traded funds (ETFs) in the Hong Kong stock market. In general, the results of this study suggest that tracking errors are comparatively greater in Hong Kong ETFs than in ETFs in the U.S. and Australia. A comparison of tracking errors between physical and synthetic ETFs also indicates that the synthetic ETFs have higher tracking errors. The magnitude of tracking errors is found to be negatively related to size but positively related to dividend yield, trading volumes of funds, and market risk. This finding is consistent with those of previous studies. However, this study also finds that expense ratio has a negative impact on tracking error, which is not consistent with previous studies, and which this paper addresses.

The Growth of Global ETFs and Regulatory Challenges

Abstract Purpose Exchange traded funds (ETFs) are one of the most innovative financial products listed on exchanges. As reflected by the size of the market, they have become popular among both retail and institutional investors. The original ETFs were simple and easy to understand; however, recent products, such as leveraged, inverse, and synthetic ETFs, are more complex and have additional dimensions of risk. The additional risks, complexity, and reduced transparency have resulted in heightened attention by regulators. This chapter aims to increase understanding of how ETFs function in the market and can potentially impact financial stability and market volatility. Design/methodology/approach We discuss the evolution of ETFs, growing regulatory concerns, and the various responses to these concerns. Findings We find that concerns related to systemic risk and excess volatility, suitability for retail investors, lack of transparency and liquidity, securities lending and counterparty exposure are being addressed by both market participants and policy makers. There has been a shift toward multiple counterparties, overcollateralization, disclosure of collateral holdings and index holdings. Originality/value The analysis contained in this chapter provides an understanding of the role of ETFs in the financial markets and the global economy that should be valuable to market participants, investors, and policy makers.

Complexity, Innovation and the Regulation of Modern Financial Markets

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions. The GFC has exposed the folly of this market fundamentalism as a driver of public policy. It has also exposed conventional financial theory as fundamentally incomplete. Perhaps most glaringly, conventional financial theory failed to adequately account for the complexity of modern financial markets and the nature and pace of financial innovation. Utilizing three case studies drawn from the world of over-the-counter (OTC) derivatives – securitization, synthetic exchange-traded funds and collateral swaps – the objective of this paper is thus to start us down the path toward a more robust understanding of complexity, financial innovation and the regulatory challenges flowing from the interaction of these powerful market dynamics. This paper argues that while the embryonic post-crisis regulatory regimes governing OTC derivatives markets in the U.S. and Europe go some distance toward addressing the regulatory challenges stemming from complexity, they effectively disregard those generated by financial innovation.