Synthetic exchange traded funds (ETFs)
More complex ETFs
As the ETF industry has grown, more complex ETF products with
different risks have been created, such as 'synthetic ETFs'.
Synthetic ETFs can be riskier than physical ETFs.
Here are some important things to consider before you
What are synthetic ETFs?
Like physical ETFs, synthetic ETFs are a type of managed
investment scheme that can be bought or sold like shares.
Synthetic ETFs rely on synthetic rather than physical holdings
of the underlying shares or other assets whose performance they are
aiming to replicate. This means that as well as directly owning the
underlying assets they use complex products called derivatives provided by financial
institutions to achieve their investment objectives.
Synthetic ETFs may be used by investors when it's impossible or
expensive to buy, hold and sell the underlying investment in
another way. For example individuals can't buy and hold
commodities, but can invest in a commodity ETF, which may be
synthetic in nature.
Synthetic ETFs traded on the ASX Quoted Assets (AQUA) market must have
the word 'synthetic' in their title, so you can easily identify
Compared with physical ETFs, the prices of synthetic ETFs can be
more closely matched to changes in the value of their underlying
investments with minimal 'tracking error' before
fees and taxes. But in return for reduced tracking error, investors
take on credit risk associated with the ETF derivative
What you need to know before you
Synthetic ETFs have many of the same features and risks as
physical ETFs, such as pricing errors, fees and costs and passive
investment strategies. (See exchange traded funds for
more information.) But synthetic ETFs also have unique features and
risks to be aware of.
Synthetic ETFs enter into contracts with third parties, or
counterparties, which are usually investment banks. Your returns
depend on the counterparty being able to honour its commitments to
While synthetic ETFs may or may not buy the shares and other
investments that they try to match, they also use complex financial
instruments known as derivatives such as 'swap agreements'. In
a swap agreement, a counterparty such as an investment bank agrees
to pay the difference between the value of the ETF's assets and the
value of the assets or index it is designed to track.
When the synthetic ETF enters a swap agreement, this creates
counterparty risk. The swap fees may or may not be included in the
ETF's 'management fee'.
Check the product disclosure statement (PDS) for
information about swap fees and other costs.
Before investing in an ETF, check its PDS for financial
information about the counterparty and how the issuer monitors and
manages counterparty risk. The higher the derivative counterparty
exposure level, the greater the proportion of the ETF's value that
will be exposed to counterparty risk.
Requirements in Australia
In jurisdictions such as the European Union there can be
significant risks in synthetic ETFs' derivatives and swap
However in Australia, ASIC has worked with the Australian Securities
Exchange (ASX) to reduce some of these risks, including
by introducing specific requirements for synthetic ETFs available
to date in Australia.
Another requirement is that counterparties for any 'over the
counter' derivatives used must be Australian deposit taking
institutions (ADIs) or an overseas equivalent (or have the benefit
of an unconditional guarantee from one of these entities).
It is still possible that counterparty exposure could rise to an
unacceptable level in exceptional circumstances. If this happens,
the ETF issuer must take action as soon as possible to restore
counterparty exposure to normal levels (for example, by requiring
the counterparty to transfer cash or other liquid assets to the
ETF). But if the counterparty fails financially and can't pay up,
investors could lose more than 10% of the value of the fund.
Specific risks with commodity ETFs
Most ETFs that track the price of commodities (such as oil or
agricultural commodities) are synthetic because they track the futures price of a commodity or index
rather than buying and tracking the price of the commodity
But sometimes the price of futures, and therefore the ETF's
price, may vary from the value of the actual commodity. For example
the price of oil indexes based on oil futures may differ from the
'spot price' for oil.
Some commodity ETFs also invest directly in futures contracts,
which need to be replaced by other futures contracts when they
expire. In certain circumstances replacing these contracts can be
expensive, reducing the value of your ETF investment.
Before investing in a commodity ETF, understand whether it aims
to track the current commodity price or the futures price, and
whether it invests in physical assets (commodities) or futures
Inverse and leveraged
Other types of synthetic ETFs are available outside Australia,
including 'inverse' and 'leveraged' ETFs and products that combine
these features. Some of these overseas products may be available
through brokers in Australia. If you're considering investing
in them, pay extra attention to the risks and note that Australian
rules to reduce the risks of synthetic ETFs may not apply.
Inverse or leveraged synthetic ETFs from an overseas exchange
are designed for extremely short-term trading. Because their prices
are reset at the end of each day, they generally shouldn't be held
for longer than that. When held for more than one day, cumulative
returns on leveraged and inverse ETFs can start to diverge from the
cumulative returns on the assets they are designed to track.
A number of overseas regulators have raised issues about the
potential market impact of these ETFs and whether they are
appropriate for all types of investors.
Inverse ETFs aim to deliver the opposite performance of the
reference index on a daily basis. An inverse share index ETF would
seek to give a positive return over a day when the share index goes
down. On a day that share index increases, the ETF should lose
For example if a share index rose by 5% on a given day, the
value of a unit in an inverse ETF over that index could be expected
to lose 5% of its value.
Leveraged ETFs aim to deliver a multiple of the performance of
the reference index on a daily basis. For example a US share index
ETF with double leverage would aim to provide a 10% return on a day
when the market increases by 5% on that day. Conversely if the
market falls by 5% in a day, the ETF investor could expect to lose
double that amount, or 10% for the day.
While leveraged and inverse ETFs may seem similar to other ETFs,
they are much riskier for retail investors. They 'reset' at the end
of each trading day, so if you invest for longer than one day your
investment returns can differ significantly from the returns of the
assets or index the ETF is designed to track. You could lose out
even if the underlying investment delivers a positive return.
Synthetic ETFs can be risky. Make sure you read
and understand the PDS, and always diversify your risks by using a
range of different providers rather than putting all your eggs in
Last updated: 14 Aug 2015