Conceptual simplicity of physical replication has won over investors
Years ago it was hard to talk about exchange-traded funds (ETFs) and not get embroiled in heated discussions about the merits – or otherwise – of physical and synthetic replication.
ETF providers soon realised their infighting was detrimental for an industry in its early stages of growth, and agreed a truce. For the past few years, public confrontations about replication methodology have been largely avoided. However, the debate has had significant consequences.
According to Morningstar data, the split in assets under management between physical and synthetic exchange-traded products – we include exchange-traded commodities here – has shifted from 55/45 per cent in 2011 to around 80/20 per cent nowadays. The number of synthetic products available for sale still surpasses the number of physical counterparts, but investors have shown a clear preference for physical replication.
And so, an interesting question for observers of the European ETF marketplace is whether synthetic replication has become a dying breed. The trend looks like further decline for the synthetics, as former advocates continue to expand their physical offerings, whether by launching new products and/or switching the replication methodology of existing funds.
There are instances where physical replication remains technically and/or financially unfeasibleJose Garcia-ZarateLyxor and db X-trackers have long been engaged in transition efforts, while Amundi recently announced plans to open up its almost wholly synthetic ETF line-up to physical replication.
These providers have taken a pragmatic business decision, but one that implicitly acknowledges the qualitative issue of how ETFs are put together has played a much more important role in investors’ decision-making processes than initially envisaged.
Besides, the notion of using derivatives as the most optimal technical option to replicate the performance of hard-to-reach markets (emerging markets, for example) or to bypass potential liquidity issues (as seen in fixed income has been undermined by the arrival of new ETFs and/or success of existing ones covering those markets and doing it physically.
So, is the synthetic replication model destined to disappear? Not entirely. There are instances where physical replication remains technically and/or financially unfeasible. Take the case of non-metal commodities, where the cost of storage – not to mention the perishable nature of some – would call for the use of futures contracts to replicate market performance.
This, however, is a largely accepted fact that does not give us a true measure of the survival chances of the synthetic replication model, which most people identify as the use of swaps. In order to assess those chances, one has to look at the areas of equity and fixed income.
It would be unwise to make the blanket statement that all ETF investors are synthetic-averse. Some feel truly at ease with the technicalities, and are willing to assume swap counterparty risk for what they consider to deliver more accurate tracking.
Ultimately, however, the way the ETF market has evolved does not augur too well for synthetic replication, and one gets the sense that, from a marketing standpoint, they are being increasingly treated as secondary options. The conceptual simplicity of physical replication seems to have won the day.
Jose Garcia-Zarate is a senior ETF analyst at Morningstar
