Synthetic ETFs were a popular option for product vendors before the Global Financial Crisis (GFC) as the embedded counterparty risk was deemed as theoretical at best.
The pricing benefits steaming from a more advantageous withholding tax treatment for US holdings have been an argument which was too compelling to ignore.
Under section 871(m) of the HIRE Act, synthetic indices with deep and liquid futures markets are explicitly excluded from the requirement to pay dividend withholding taxes.
Meanwhile, physical ETFs domiciled in Ireland are subject to 15% withholding tax on US dividends while other jurisdictions such as Luxembourg pay 30%.
As counterparty risk for derivatives took centre stage during the GFC, those benefits seem to have lost their appeal to investors.
Warnings from the International Monetary Fund, discrediting synthetic ETFs as a potential source of instability during times of market turmoil seem to still resonate. Therefore, the market share for synthetic ETFs fell from approximately 40% pre-2008 to less than 15% today.
Betting on more investors willing to recalibrate their selection process, we recently saw some prominent launches of synthetic ETFs from giants like BlackRock.
As the embedded swaps are now often split across different counterparties, risks are more balanced than they were in the past.
A positive side effect: swaps are nowadays traded only after competition among banks for the best price. Therefore, the economic terms of those swaps have improved as well.
A structural tax advantage, more balanced counterparty risk and improved pricing should be a recipe too tempting to ignore, at least in theory.
What is ignored in the discussion so far are the hidden reputational risks arising from the nature of the swaps used within ETFs.
Those may by far outweigh any other benefit and could be the main headwind to synthetic ETFs claiming back their former glory.
Usually, synthetic ETFs are trading swaps within it is agreed that the swap counterparty pays the index return including all dividend payments to the ETF.
In exchange, the swap counterparty receives a fee and the return of the securities in a collateral portfolio.
Therefore, the funds of a synthetic ETF are not invested in the replicated index itself but in a basket of securities that serves as collateral for the swap counterparty.
The collateral portfolio barely coincides with the replicated index. For example, a synthetic ETF on European equities may also hold Japanese equities in the collateral portfolio.
The decision of the composition of the basket is usually driven by the financing needs of the swap counterparty.
This is exactly where the trouble (potentially) starts. While there are some basic criteria for what kind of collateral is acceptable, the composition of a collateral basket is subject to ongoing changes.
This may lead to situations in which companies (e.g. oil producers) which do not meet the ETF’s or the vendors' commitments in regard to Principal Adverse Impacts (PAI) could be part of the collateral basket. PAIs are defined by the EU´s Sustainable Finance Disclosure Regulation (SFDR) as an investment decision’s negative impact on an ESG challenge.
ESG-related funds (SFDR Article 8 and 9) are considering at least most of the 18 existing PAIs. Hence, holding collateral which is inconsistent with the PAI commitment can already pose a reputational threat to the product vendor. The same is true for the product distributor.
A rising number of banks and asset managers are committing to taking those PAIs into consideration and not promoting companies or assets which fail to do so.
Technical experts may scratch their heads, wondering where the issue is. The collateral portfolio is just collateral.
The ETF is not making any active investment decision and is not economically engaged in those companies. Its economic investment is still solely within the tracked index.
However, there is also a school of thought which argues that even the possibility to use those “ESG unfriendly” shares as collateral would already contribute to the financing needs of the specific companies.
This argument is often employed by environmental activists, usually in the context of greenwashing accusations.
Due to the sensibility of the topic, becoming related to greenwashing is something that wants to be avoided as much as possible. Fund allocators most weigh their options in dealing with the risk of being accused.
Potential solutions
Firstly, doing nothing and citing the economic exposure of the ETF as the main benchmark to measure if certain ESG policies are fulfilled. While this looks like an argument that can hold in theory, the reputational risks are noteworthy.
In order to defend against potential accusations in such case, very technical details of swap mechanisms must be discussed. Those may serve as weak defence against a hypothetical headline such as “big oil in ESG ETFs – greenwashing continues”.
The second option would be to implement ongoing controls in order to monitor the collateral portfolio.
While being rather easy (but potentially costly) for the vendor, it could be much harder for distributors. Recall that for the buyer of the ETF the composition of the collateral and the related requirements are unknown upfront and can change constantly.
Establishing effective controls on the collateral portfolio may thus be costly or even undoable for smaller buyers.
Therefore, the only “bullet-proof” solution would be to insist that the ETF provider includes appropriate filters in the conditions of the swap in regard to which securities are acceptable collateral.
But even in such circumstances, any buyer would likely still need to implement controls in order to not purely rely on the vendors assessment.
The third option obviously consists of the possibility to conclude that despite the doubtless performance benefits of synthetic ETFs, the embedded reputational risk and required efforts to mitigate those risks may not be worth it.
If you will, this would be the acknowledgement of an asymmetric risk-return situation as a headline like “bank is forgiving 15bps of performance due to not using synthetic ETFs” is much less of an eye-catcher.
Stephan Kemper is chief investment strategist, team manager advisory desk, and Kolja Wagner is financial product adviser, sustainable investments, at BNP Paribas Wealth Management
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.
