Nick Bruining: Avoid the smoke and mirrors of synthetic exchange-traded funds

With exchange-traded funds increasing in popularity, investors are being warned about the risks of pouring money into the investment vehicles — particularly “synthetic” varieties.

Investors might not fully understand the underlying risks of ETFs that use this approach to investing, making incorrect assumptions about the make-up of the investments.

An ETF is a pooled investment vehicle, traded on stock exchanges such as the Australian Securities Exchange.

The ASX reckons more than $200 billion is now invested in ETFs — a 20-fold increase over the past decade.

They are a popular vehicle for investors wanting exposure to a diversified pool of growth assets such as shares and are used heavily in self-managed superannuation fund arrangements.

ETFs are regarded as a lower-cost alternative to conventional managed investment funds which are traditionally distributed through financial advisers. Many traditional managed funds now also offer an ETF equivalent.

ETFs are listed on the ASX and other international exchanges and are purchased through stock brokers including discount online share services. That makes some ETFs ideal for smaller and first-time investors and for more sophisticated investors that are designing bespoke, complex investment portfolios.

Early versions of ETFs were predominantly regarded as “passive” funds, where the underlying investment mix matched standard indices such as the ASX-S&P200, which represents the top 200 stocks by capital value.

“Active” ETFs, on the other hand, actively trade assets within the fund while specialised ETFs can follow specific themes. For example, there are ETFs that invest purely in gaming company shares, cryptocurrencies and others which use short-sale arrangements that benefit when stock prices are falling.

While broader ETFs typically provide high levels of diversification, investors should be aware that sometimes the underlying assets can be illiquid and mask secondary risks like movements in foreign currencies when some of the underlying assets are held overseas.

While the inherent investment risks increase with reduced diversification, an increased risk applies when the ETF uses synthetic assets.

In essence this type of ETF does not hold the physical assets that determine the underlying investment values attached to the ETF.

Instead, the fund manager will use a mix of real assets and derivative instruments which mimic an asset, but where there is no direct interest in the specific asset. These “non-real” assets are broadly described as “synthetics”.

Synthetic assets introduce another significant area of risk called counter-party risk. That is, the company providing the synthetic asset faces a situation where the value of the asset does not have the cash backing to support any large-scale sales or cashing-in of the synthetic asset.

Admittedly, no synthetic ETF has failed since the first ETF appeared in 2001, but that doesn’t negate the very real risks that can exist.

For that reason, many financial advisers prefer to recommend ETFs backed by real assets.

Nick Bruining is an independent financial adviser and a member of the Certified Independent Financial Advisers Association