Morningstar gives qualified backing to synthetic ETFs

Investor protection within the ETF sector is rising, though further reforms are still necessary, says a new report from Morningstar.

A large majority of synthetic ETFs worldwide are subject to regulation that limits the amount of counterparty exposure to any single issuer via a derivative. Most providers offer far more protection than is mandated by local regulation, the report said.

Morningstar’s comments contrast significantly the series of criticisms of synthetic ETFs that have been made since last year both in the private and the public sectors. A number of international regulatory bodies have expressed concern about the risks involved, including the International Monetary Fund, the Financial Stability Board, the Bank for International Settlements and the Financial Services Authority in the UK.

Morningstar said: “We find that in general, synthetic ETFs have lower TERs (with some Asian ETFs being notable exceptions) and superior tracking relative to traditional ETFs, especially in those instances where the underlying asset class is smaller and/or less liquid (e.g. emerging market equities).”

Morningstar used asset flows data to infer a degree of causality between the barrage of bad publicity served against synthetic ETFs over the past twelve months, and the concurrent net outflows from these funds.

In its report, Morningstar concluded: “There remains a real need for common industry standards around labeling synthetic ETFs, disclosing information about the funds’ asset/collateral baskets, counterparties and embedded costs. In Europe, it remains to be seen whether a push toward harmonisation of best practices ultimately comes from within the industry itself, or is handed down from regulators.”

The report analysed data on synthetic ETFs in Europe, Asia, Australia and Canada, and highlights the progress that the ETP industry has made towards increased investor protection and greater transparency. The report also calls out those areas where there remains room for improvement. 

“We reiterate what we believe to be industry best practices, and provide investors with profiles of the practices employed by each provider to assist them in understanding these funds’ structural risks.”

“We conclude that there remains a real need for common industry standards around labeling synthetic ETFs, disclosing information about the funds’ asset/collateral baskets, counterparties and embedded costs. In Europe, it remains to be seen whether a push toward harmonisation of best practices ultimately comes from within the industry itself, or is handed down from regulators.”

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