Lyxor, Europe’s third largest provider of exchange-traded funds, has announced that three of its largest ETFs are to be converted to physical replication.

Arnaud Llinas, Global Head of ETFs and Indexing at Lyxor.

The ETFs in question are linked to the CAC 40, IBEX 35 and DAX indices and have approximately €5 billion in assets.

The conversion will take place on 11 July 2014, after which each fund will be directly invested in equities in their respective underlying index.

Arnaud Llinas, global head of ETFs and indexing at Lyxor, said: “Our strategy is to offer our clients the most efficient ETFs by selecting the most appropriate replication method for each index. We believe we can now offer a better product on the CAC 40, IBEX 35 and DAX by using a direct replication method”.

The conversion follows Lyxor’s announcement in September 2012 that it would launch a range of physically replicated ETFs. Up to then the Paris-based provider had tended to favour a swap-based replication approach to ETF construction. However, ETFs constructed via this so-called “synthetic” replication methodology have in recent years been out of favour with investors, with asset flows demonstrating investors’ preference for physically replicated structures.

Synthetic ETFs typically deliver the performance of the underlying index by entering into a swap agreement with a counterparty to receive the performance of the index. This counterparty is usually an investment bank and often parent to the ETF provider itself, raising concerns about counterparty risk and conflicts of interest. Moreover, the collateral guaranteeing the swap may bear no resemblance to the underlying securities, prompting many to question the suitability of such structures in the event of a default by the swap counterparty.

Whilst swap-based ETFs can offer many notable benefits, including reduced tracking error (especially in illiquid emerging markets) and lower costs, and are often over-collateralised thereby protecting fund holders in the event of a default by the counterparty, these benefits have failed to fully offset investors’ concerns.

Since commencing the roll out of physical ETFs and converting synthetic products, Lyxor has seen assets under management increase. This has continued this year, with AUM up by 13% from the beginning of the year to the end of May, with net investment inflows of $3.5 billion.

Globally, Lyxor has approximately €36.5 billion of ETF assets under management.