Why are some ETFs riskier than others?
Exchange traded funds (ETFs) can come with a number of benefits, such as relatively low costs and access to a wide range of investments, but some are more complex and risky than others.
The majority of ETFs listed on the Australian sharemarket aim to replicate the performance of a group of assets – a share market index, for example – by physically buying the shares that make up the index.
However, some ETFs don’t actually buy the assets whose performance they are trying to replicate but instead buy complex financial contracts known as derivatives in order to deliver their investment objectives.
These ETFs are known as ‘synthetic’ ETFs. You can spot them because they have ‘synthetic’ or ‘synth’ in their name.
Why are they synthetic?
In some cases, it’s just not practical for an investment company to own the products whose changes in value they’re trying to track.
For example, the Betashares Agriculture ETF - Currency Hedged (Synthetic) (QAG) is an agriculture fund, which according to BetaShares “provides exposure to the performance of a basket of the most globally significant agricultural commodities”.
Rather than buying and storing the commodities, which in this case include corn, wheat, soybeans and sugar, the provider aims to deliver returns that replicate changes in their value through the use of derivatives, such as ‘swap agreements’.
What are the risks?
A key risk that is specific to synthetic ETFs is known as counterparty risk. The ‘counterparty’ is the company on the other side of the swap agreement, for example, and is usually an investment bank.
Swap agreements are a contract between two (or more) parties, with the counterparty promising to pay the difference between the value of the ETF’s assets and the value of the assets it is trying to track. Again in the case above, those underlying assets are agricultural commodities.
What the ASX says
The ASX says that if you invest in synthetic ETFs “you are subject to the risk that the counterparty to the derivative may fail to meet some or all of their obligations”.
This may be unlikely but the collapse of US investment bank Lehman Brothers served as a reminder that it can happen. The ASX has certain requirements in place to mitigate the counterparty risk.
“If for some reason the counterparty fails to meet its obligations to the ETF, the fund may not be able to deliver its return objective and investors could lost up to 10% or more of the value of their investment in the ETF,” according to the ASX.
It’s important to read the product disclosure statement (PDS) for an ETF and understand the risks involved before investing.