Lyxor, one of Europe’s leading providers of exchange-traded funds (ETFs), has announced plans to a launch a range of physically replicated ETFs. Until now, the Paris-based asset manager and subsidiary of French banking giant Societe Generale had favoured a swap-based, synthetic replication approach.
Lyxor, one of Europe’s leading synthetic ETF providers and a subsidiary of Societe Generale, has announced plans to a launch a range of physically replicated ETFs.
While Lyxor said the decision was designed to fully address investors’ requirements and offer its clients “the best of both worlds”, the move has been seen as a direct response to investors’ growing preference for physically replicated ETFs over their synthetic counterparts.
This preference has been borne out in recent asset flows, with inflows into physical ETFs far exceeding inflows into synthetic equivalents. So far this year, physical ETFs in Europe have experienced net inflows of $13,176m compared to net inflows of just $394m for synthetic ETFs, according to data compiled by ETFGI, a London-based ETF consulting firm, as of August month-end.
On a relative basis, Lyxor’s synthetic range has fared even worse, experiencing year-to-date net outflows of $506m. This contrasts with leading physical providers such as iShares, SPDR and HSBC, which have enjoyed net inflows of $9,661m, $1,268m and $473m respectively. Last year followed a similar pattern. For the whole of 2011, Lyxor saw its ETF assets under management shrink by $9,568m. Conversely, iShares, for example, added $15,885m.
The relative outperformance of physical ETF providers in gathering assets corroborates the findings of a number of recent surveys, which have revealed overwhelmingly that investors increasingly prefer the physical replication model to a synthetic, swap-based approach.
One such survey sponsored by Morningstar showed that 89% of survey participants preferred physical ETFs over synthetic ETF, while another sponsored by Legal & General found that 69% of advisers were concerned about the counterparty risk associated with swap-based ETFs.
Talking back in May, Ben Johnson, Morningstar’s director of European ETF research, said: “Despite the efforts made by providers of synthetic replication ETFs to improve the level of transparency and investor protection in their product line-ups, respondents remain wary of swap-based ETFs.”
Investors’ biggest concern regarding swap-based ETFs seems to be counterparty risk (the risk that a swap counterparty will default on its obligations), a factor widely blamed for Lyxor’s decline in assets under management. In particular, Lyxor’s use of its parent company (Societe Generale) as the sole swap counterparty has come under scrutiny, especially since Societe Generale’s shares have suffered on fears surrounding the bank’s potential exposure to Greek, Spanish and Italian debt.
This concern seems to have prevailed despite steps taken by Lyxor (and, similarly, by other synthetic ETF providers) to minimise counterparty risk. These steps have included over-collateralisation, where the collateral underpinning the swap exceeds the exposure to the counterparty, and the implementation of safeguards guaranteeing the minimum quality and liquidity of collateral.
But while Lyxor is clearly responding to investors’ preference for physically replicated products, the company has stressed its commitment to its existing product line-up and remains a vocal proponent of the swap-based approach. Indeed, as synthetic ETF providers such as Lyxor have consistently argued, the swap-based approach does offer a number of advantages over physical ETFs, including reduced tracking error (especially in illiquid markets) and lower costs.
By offering both physical and synthetic ETFs, Lyxor is allowing clients to choose the replication model with which they feel most comfortable and which best suits their investment needs. This strategy has also been taken by UBS, which recently rolled out a range of ETFs on the London Stock Exchange using both synthetic and physical replication methodologies.
By contrast, Credit Suisse last year came out in favour of the physical method and converted many of its funds from synthetic to physical replication.
Lyxor’s decision to keep the synthetic option open, however, may prove prescient. The introduction of financial transaction taxes on cash trades could exact a hefty burden on physical ETFs, putting them at a significant cost disadvantage to synthetic funds, while at the same time a resolution to the Eurozone crisis and a strengthening of banks’ capital positions could ease the pressure on synthetic providers. These developments could potentially spur renewed interest in synthetic ETFs as investors re-examine the benefits of the approach.