Swap Based (synthetic) vs Full Replication

[Cookie]

I have avoided swap based ETFs originally as I didnt have time to understand them and I didnt like the sound of them

However some are cheaper than a full replication ETF and I have tried to look at these again. I am still not completely sure I understand them, but has anyone used them and feel they have particularly benefits that outweigh the risk?

[Alaric]

I have avoided swap based ETFs originally as I didnt have time to understand them and I didnt like the sound of them

"Synthetic" can mean that instead of investing directly in the shares underlying an index, they invest in derivatives (akin to spread betting) which have the same effect.

Counterparty risk can be a potential problem. That's where your performance is based on a promise from a third party to deliver a return, rather than holding all or some of the securities comprising an index.

[Lootman]

I have avoided swap based ETFs originally as I didnt have time to understand them and I didnt like the sound of them

"Synthetic" can mean that instead of investing directly in the shares underlying an index, they invest in derivatives (akin to spread betting) which have the same effect.

Counterparty risk can be a potential problem. That's where your performance is based on a promise from a third party to deliver a return, rather than holding all or some of the securities comprising an index.

When considering counterparty risk I think it is important to differentiate between three types of synthetic ETF as each has a different type of counterparty:

1) ETFs that use swaps. These are OTC derivatives and so the counterparty risk is with the IB that takes the other side of the swap trades.
2) ETFs that use options and futures. These are exchange-listed derivatives and so the counterparty is the exchange. Exchanges have a negligible counterparty risk.
3) ETNs - these are credit instruments and so the counterparty risk for an individual investor is the issuing entity itself. You're basically a bondholder.

[OhNoNotimAgain]

I have avoided swap based ETFs originally as I didnt have time to understand them and I didnt like the sound of them

"Synthetic" can mean that instead of investing directly in the shares underlying an index, they invest in derivatives (akin to spread betting) which have the same effect.

Counterparty risk can be a potential problem. That's where your performance is based on a promise from a third party to deliver a return, rather than holding all or some of the securities comprising an index.

When considering counterparty risk I think it is important to differentiate between three types of synthetic ETF as each has a different type of counterparty:

1) ETFs that use swaps. These are OTC derivatives and so the counterparty risk is with the IB that takes the other side of the swap trades.
2) ETFs that use options and futures. These are exchange-listed derivatives and so the counterparty is the exchange. Exchanges have a negligible counterparty risk.
3) ETNs - these are credit instruments and so the counterparty risk for an individual investor is the issuing entity itself. You're basically a bondholder.

Don't kid yourself. Whenever you place money with someone else there is always the risk you won't get it back.

The question to ask about all ETFs is why is it better for someones else to seek to replicate the returns of an index on your behalf, by trading, rather than just buying and holding the underlying constituents and accepting that you cannot trade out at 10:32 am and back in again at 14:47.

That provision of liquidity costs money. And only one person provides that; you:-

The Punter Always Pays.

[Lootman]

Whenever you place money with someone else there is always the risk you won't get it back.

But that risk varies which is why I gave three different cases.

The question to ask about all ETFs is why is it better for someones else to seek to replicate the returns of an index on your behalf, by trading, rather than just buying and holding the underlying constituents and accepting that you cannot trade out at 10:32 am and back in again at 14:47.

That provision of liquidity costs money. And only one person provides that; you:-

The Punter Always Pays.

The punter always pays but the point is how much. For instance the Vanguard FTSE-100 index ETF costs 0.06% a year. A well known open-ended index fund run by a Lemon costs 1.2% a year. That open-ended fund is 20 times more expensive than the ETF.

What matters is the fidelity of the tracking methodology. And paradoxically the most faithful method of mirroring an index is actually an exchange-traded note, although that does come with issuer risk. The tracking errors of most major market ETFs, and their spreads, are negligible.

That said I prefer full physical replication myself. Not because it is cheaper or less risky, but because it gives the opportunity to do stock lending to further reduce the cost. Now that we are seeing zero cost ETFs from Fidelity, and perhaps others soon, it may be just a matter of time before fund managers pay you to hold their ETF. They will just make money on the stock lending, or share that revenue with you.

[OhNoNotimAgain]

Whenever you place money with someone else there is always the risk you won't get it back.

But that risk varies which is why I gave three different cases.

The question to ask about all ETFs is why is it better for someones else to seek to replicate the returns of an index on your behalf, by trading, rather than just buying and holding the underlying constituents and accepting that you cannot trade out at 10:32 am and back in again at 14:47.

That provision of liquidity costs money. And only one person provides that; you:-

The Punter Always Pays.

The punter always pays but the point is how much. For instance the Vanguard FTSE-100 index ETF costs 0.06% a year. A well known open-ended index fund run by a Lemon costs 1.2% a year. That open-ended fund is 20 times more expensive than the ETF.

What matters is the fidelity of the tracking methodology. And paradoxically the most faithful method of mirroring an index is actually an exchange-traded note, although that does come with issuer risk. The tracking errors of most major market ETFs, and their spreads, are negligible.

That said I prefer full physical replication myself. Not because it is cheaper or less risky, but because it gives the opportunity to do stock lending to further reduce the cost. Now that we are seeing zero cost ETFs from Fidelity, and perhaps others soon, it may be just a matter of time before fund managers pay you to hold their ETF. They will just make money on the stock lending, or share that revenue with you.

I would be interested to read more descriptions of the items on page 18 of this document.

https://www.vanguardinvestor.co.uk/rs/g ... nts/959/gb

The swing from £268m of net gains on financial instruments in one year to £113m the next surely deserves some explanation.

[Alaric]

The swing from £268m of net gains on financial instruments in one year to £113m the next surely deserves some explanation.

Surely that's just realised and unrealised gains? If the assets are stated at market value, changes in market value will go through the revenue account.

[OhNoNotimAgain]

The swing from £268m of net gains on financial instruments in one year to £113m the next surely deserves some explanation.

Surely that's just realised and unrealised gains? If the assets are stated at market value, changes in market value will go through the revenue account.

No,
Net Increase (Decrease) in Net Assets Attributable to Holders of Redeemable Participating SAhares in yr to end June 2108 was £112m, down from £267m.

Financial instruments is not a term normally used to describe shares.

[Alaric]

Net Increase (Decrease) in Net Assets Attributable to Holders of Redeemable Participating SAhares in yr to end June 2108 was £112m, down from £267m.

Financial instruments is not a term normally used to describe shares.

Net increase of assets is presumably the aggregate of all changes. Note the similarity to the "change in financial instruments" figure.

Vanguard being an American company, I would expect the accounts to be written using American jargon.