Synthetic ETFs Lose $1.9B in Europe

Investors in Europe pulled more money out of derivative-based exchange-traded funds last month while adding to funds that own stocks, bonds and commodities, amid a debate about the risks of so-called synthetic ETFs.

The synthetic funds, which replicate returns of an index without owning the underlying securities, had redemptions of $1.86 billion in October, while physically backed funds attracted $3.11 billion, according to a report by BlackRock Inc. (BLK), the world’s largest provider of ETFs. The trend was most pronounced in European equities and commodities.

“In Europe, the fortunes of physically backed and derivative-backed products have diverged over the last three months with investors showing a preference for funds and products that purchase the underlying assets,” Kevin Feldman, a managing director at New York-based BlackRock, said in the statement.

Synthetic funds, which are mostly sold in Europe, have come under scrutiny this year as international regulators raised concerns that investors may not be aware of the funds’ risks. BlackRock, whose line-up of ETFs is dominated by physically backed funds, last month called for clearer labeling and urged U.S. lawmakers to bar funds that use derivatives from calling themselves ETFs. Providers of synthetic products argue their risk profile doesn’t differ from traditional ETFs that lend securities, as they are also exposed to counterparty risk.

Synthetic products account about 40 percent of ETF assets in Europe, according to BlackRock. In the U.S., synthetic ETFs are limited to leveraged and inverse funds, as well as some commodity-based funds. The Securities and Exchange Commission suspended approvals for new derivative-based ETFs in March 2010.

BlackRock’s ‘Agenda’

European investors pulled $608 million in October from synthetic ETFs that invest in broad European stock categories, while adding $779 million to ETFs that invest in the underlying stocks, according to BlackRock. Synthetic gold ETFs lost $2.2 million while ETFs backed by physical gold took in $1.2 billion.

Synthetic ETF providers such as Lyxor, a unit of Paris- based Societe General SA, and New York’s ProShare Advisors LLC, have criticized BlackRock for its proposals. Lyxor Chairman Alain Dubois said in an interview in October that BlackRock’s warnings ignored risks associated with securities lending by physical ETFs. ProShare’s Chief Executive Officer Michael Sapir said BlackRock’s proposals promoted “its own agenda.”

BlackRock’s global ETF assets have grown 2.6 percent to $612 billion this year. Among the industry’s top 10 players, the only providers whose assets shrank this year were Europe’s two largest synthetic providers. Assets at db x-trackers, a unit of Frankfurt-based Deutsche Bank AG (DBK), fell 1.3 percent to $49.5 billion and Lyxor’s declined 24 percent to $40.6 billion.

Vanguard’s Gain

Vanguard Group Inc. in Valley Forge, Pennsylvania, which sponsors only physically backed funds, added 15 percent to $170.5 billion. Assets at ProShares, the largest synthetic provider in the U.S., rose 5.5 percent to $24.9 billion.

Synthetic ETFs typically rely on futures and total return swap contracts to generate their return. Physically backed ETFs purchase the stocks, bonds or commodities in the index they seek to track.

The U.K. Financial Services Authority in a June report raised concerns about counterparty risk and over the quality and liquidity of collateral that derivatives providers give synthetic ETFs to protect them in the event of the counterparty’s bankruptcy.

The International Monetary Fund and the Bank for International Settlements also have issued reports examining whether synthetic ETFs could present a systemic risk because of reduced liquidity of collateral during a market crisis.

Counterparty risk refers to the chance that the opposite party in a contract will fail to meet its obligations. For a synthetic ETF, the risk is that its derivative provider will go bankrupt, leaving the fund with no return. For physical funds that lend securities, a common practice, the danger is that a borrower will collapse and fail to return them.

To contact the reporter on this story: Christopher Condon in Boston at ccondon4@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

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