Investors misunderstand dangers of ETFs

Survey1Industry communication about the dangers of synthetic exchange-traded funds (ETFs) has led investors to underestimate the risks attached to physically replicating products, according to an annual ETF survey by the Edhec-Risk Institute.

The survey suggests investors are widely aware that synthetic ETFs, which use swap transactions to replicate their index, are exposed to counterparty risk. But investors were much less likely to say that physical ETFs, nearly all of which engage in securities lending, are also risky.

Respondents gave physical ETFs an average risk score of 2.28 out of 3, which means not risky, but gave synthetic ETFs a score of 1.41.

“Industry communication on the risks of ETFs has led to the counterparty risk of physical ETFs being underestimated,” said the report.

Securities lending is widespread among physical ETFs because it allows providers to gain extra basis points on the securities they hold, but it means investors are exposed to the risk that a borrower fails to return the securities on time.

The report also suggested a lack of understanding about which ETFs use securities lending. When asked to assess operational risk caused by the practice, respondents gave a higher risk score to synthetic replication, even though synthetic ETFs do not use securities lending directly.

The survey revealed a preference for full physical replication over both synthetic replication and sampling replication, which is a form of physical ETF in which the fund holds a subset of securities from the index.

However, respondents had a preference for synthetic ETFs if an index was hard to track, for instance for illiquid asset classes or indices with more than 1,000 items.

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