Swap ETF – How does synthetic replication work?

You may be in the process of building up a portfolio and are looking for suitable exchange-traded funds. In the course of your research, you will come across the topic of replication methods. Beginners often read that the synthetic replication method is more risky. But is this true and how exactly do swaps work?

The replication methods

How safe are ETFs? This is partly due to the so-called replication method. An exchange-traded fund is always based on an index. There are different ways in which ETFs replicate their index. A rough distinction can be made between physical and synthetic replication.

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What does physical replication mean?

The aim of a physical exchange-traded fund is to replicate the index as closely as possible. For this reason, all the securities it contains are replicated. It is therefore a direct replication, which is why this replication method is also known as full replication.

This method is illustrated with an example. An exchange-traded fund on the DAX, the German share index, therefore contains all 40 companies included. These stocks or shares are bought according to their weighting.

This type of replication can be more expensive and is time-consuming for the ETF provider. The exact composition must be checked at regular intervals. In addition, shares have to be bought or sold to ensure that the index is always accurately replicated. These fees can have an impact on ongoing costs such as the TER or total expense ratio.

Sampling is also part of physical replication and represents a kind of further development:

• The exchange traded funds are purchased physically. The provider decides on a pre-selection and buys a representative quantity
• In this way, not all of the stocks included are bought exactly, only the most important and large positions
• Items that are only slightly present in the index are neglected

The advantage of this replication method is that it saves costs. Indices that contain a large number of securities, such as global ETFs, often have positions with a weighting of just 0.01 per cent. These are not taken into account, which eliminates transaction costs and reduces the TER.

The distribution of the physical replication is either accumulating or distributing. Accumulating exchange traded funds reinvest the dividends they earn. If you have a distributing option, you will receive the dividends directly into your account.

How does synthetic replication work?

Unlike physical exchange traded funds, synthetic replications only track their index indirectly. There is a contract between the provider of your ETF and a swap partner, such as a bank:

• In some cases, the swap partner is the parent company of the actual provider
• Synthetic replication is somewhat more complex than physical replication.

This trade is based on the assumption that both portfolios will generate a similar return, otherwise one partner would realise losses. The counterparty undertakes to pay out the return on the index including all dividend payments.

In return, he receives a fee, the so-called swap fee. Exchange traded funds and partners therefore receive their partner’s return. This is an over-the-counter (OTC) transaction.

But why are indices only tracked indirectly if it would be possible for investors to actually buy the positions?

• The advantage of the physical replication type is that illiquid indices can be replicated
• This advantage is particularly evident with small thematic ETFs
• It is often an ETF with high returns from a special niche
• This makes it easier to invest in markets that are difficult to access

Aspects such as taxes and minimum costs are therefore taken into account in the actual composition of the synthetic variant. An exchange-traded fund on the DAX, for example, can also contain bonds in a foreign currency. The performance is unimportant here, as the return is exchanged.

Types of swaps

There are different types of swaps:

• Funded,
• Fully Funded and
• Unfunded Exchange Traded Funds

A funded variant provides additional protection against the risk of default. The equivalent value of the ETF is deposited as collateral so that it can be used in the event of a default. The risk for investors is therefore particularly low.

In the fully funded variant, no basket of securities is held. The assets are invested as a whole in an index swap. In addition, high collateral is deposited in order to reduce the counterparty risk.

The last variant is the unfunded option. In contrast to the options mentioned above, this option does not require any further collateral from the counterparty. By law, the risk of loss may not exceed ten per cent.

Exchange traded funds that replicate in the synthetic way are usually accumulating. In this way, you are more likely to benefit from the compound interest effect, as interest accrues on increasingly larger assets.

Advantages and disadvantages of swap ETFs

A look at the positive and negative aspects can help to better understand how it works and the associated consequences.

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Advantages of the Swaps ETF

One positive aspect of the synthetic replication type is the often lower fees. These are lower compared to physical exchange traded funds, as there are fewer transaction costs.

Niche market and thematic ETFs are also an advantage of the synthetic replication type. It is often a top ETF that can increase returns. These can be replicated better than with the physical variant. Swaps give you access to new markets.

Examples would be commodity ETFs. There are various reasons for this, such as time zones or restrictions. Without the possibility of synthetic replication, the costs would be high.

Theme ETFs are more suitable for advanced investors. They are often significantly less diversified and contain fewer companies, which increases the risk of the portfolio. They invest in innovative sectors or capitalise on hype. Thematic ETFs offer an opportunity for investors who already have a global world portfolio and would like to expand and develop it.

The differences in performance between the exchange-traded fund and the index are indicated by the tracking error. This is a key figure that is used to estimate the quality of an ETF:

• Synthetic replication leads to lower tracking error values
• However, this does not always have to have an impact on returns

Disadvantages of the swap ETF

As already explained, synthetic replication involves trading with a counterparty. This trade gives rise to what is known as counterparty risk, which is related to whether the other party fulfils its obligations.

As mentioned above, the limit of the possible loss is 10 per cent. This is regulated by law under the EU’s UCITS Directive. In reality, this risk is usually much lower. Additional collateral protects you as an investor from further losses.

One disadvantage is the greater complexity of this type of replication. It can be much more complicated to understand synthetic exchange-traded funds, how they work and the securities they offer, especially for beginners who are just starting out in the world of finance and investing.

One problem with synthetic replication is that there is often less transparency compared to physical replication. The actual underlying portfolio is often not published and cannot be found in the factsheet. Otherwise, the usual ETF fund disadvantages apply. The following table provides an overview of all the advantages and disadvantages:

Do swaps make sense?

Securities based on synthetic replication are also safe investments. You don’t have to be afraid of a total ETF loss. There are already a number of measures in place to minimise the risks for investors.

These include laws such as the UCITS Directive, but also collateral that can be deposited and actively utilised in the event of a loss. A risk of 10 per cent does not exist in most cases.

Whether a swap exchange traded fund is worthwhile or not depends on the investor and which securities you are interested in. If you already have a broad-based global portfolio and would like to increase your returns through thematic ETFs and special niches, for example, synthetic replication could be an option.

The lower TER can also be worthwhile in some cases and increase the overall return. Of course, this depends on the specific ETF you are interested in. So there are certainly situations in which synthetic replication can be worthwhile.

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Conclusion: Swap ETF vs. physical replication

Each exchange-traded fund is based on an index. These are replicated in different ways, either physically or synthetically. Full replication or physical replication replicates an index as accurately and directly as possible – the positions it contains are actually purchased.

The sampling method is a further development. Investments are made in a representative selection and in the most important and largest positions. This saves costs compared to physical replication.

Swaps are somewhat more complex in structure, as a trade is made between the provider and another party, often a bank or the parent company. The counterparty undertakes to pay out the yield and dividend payments.

All types have their advantages and disadvantages. Swap exchange traded funds are characterised by lower fees and a lower tracking error difference. They enable the mapping of special niches. On the other hand, there is a possible counterparty risk, greater complexity and lower transparency.

In summary, the risk of synthetic replication is somewhat higher, but manageable due to laws, collateral and investor management. Find out more about ‘crisis-proof investments’ and ‘the 10 best ETFs’ here!

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