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Synthetic Exchange Traded Funds, ETFs Under Regulatory Radar

Synthetic exchange traded funds have come under growing scrutiny this year amid concerns from regulators that investors may not be aware of the products' risks.

Synthetic ETFs, also known as a swaps-based exchange-traded fund, attempt to replicate returns of an index like the S&P 500. Unlike conventional, plain-vanilla exchange-traded funds, synthetic ETF do not own any of the shares listed on the index they track. Instead, synthetic ETFs use derivatives to get exposure to the indexes they track.

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The technique involves a counterparty — and that means counterparty risk. If the counterparty, typically a bank, is unable to deliver on the promised returns of the index being tracked, investors in the ETF could suffer severe financial losses.

A recent report by the Financial Stability Board (FSB) highlights the latest trends in the synthetic ETF market and the potential dangers that the products potentially pose. Among those dangers:

Counterpart default
Collateral risk
Liquidity risk
Lack of transparency
Conflicts of interest

Leveraged and inverse are two types of synthetic exchange-traded funds. This past fall, both leveraged and inverse ETFs were the subject of a broad regulatory review by the Securities and Exchange Commission (SEC). Among other things, the SEC was concerned about the transparency of the underlying instruments ETFs invest in, valuation accuracy and the kinds of disclosures being made to less-sophisticated investors.

Leveraged ETFs attempt to double the return of an index on a daily basis. Inverse ETFs deliver the opposite of the performance of the underlying benchmark index that it tracks.