Synthetic ETFs form about 11% of the APAC ETF market, whereas they are as much as 37% of the European ETF market. However, due to regulatory restrictions and differing market evolution in the US, synthetic ETFs comprise only about 3% of the overall ETF market, according to a new report, Synthetic Exchange-Traded Funds in Asia-Pacific: A Losing Battle?, from Celent.



The growth of exchange-traded funds (ETFs) has had a profound effect on the global capital markets. The profitability of both brokerages and "active" fund managers has been lower as a result of ETFs. The ETFs are seen as a simpler and cheaper mode of investment by institutional and retail investors alike.
 
Competition in the ETF space has led to greater innovation. A number of new ETF products that have become popular include synthetic and inverse ETFs, actively managed ETFs, emerging market bond index ETFs, and factor-based weighted ETFs.
 
Equity continues to be the leading asset class in terms of ETF assets under management (AuM) in 2011. Other popular asset classes include fixed income, currency and, increasingly, commodities in light of the volatility in equity markets in recent times.
 
A few firms (such as BlackRock, State Street Global Advisors, and Vanguard) dominate the global ETF market. In Asia-Pacific, the leading ETF providers include Deutsche Bank, BlackRock, and Société Générale's Lyxor. Of these Deutsche Bank and Lyxor are better known for their synthetic ETF products.
 
Europe has been the leading market for synthetic ETFs globally. Regulations have restricted the growth of synthetic ETFs in the US market, and the development of these ETFs is still in its nascent stage in the Asia-Pacific region.
 
In terms of costs for physical and synthetic ETFs, the latter seem to be cheaper. This is an important reason for the popularity of synthetic ETFs. The total expense ratio (TER) for synthetic ETFs is lower, because often asset managers are able to take advantage of collateral availability with their affiliated banks.
 
Hong Kong and Singapore have been the leading markets for synthetic ETFs in Asia. The two markets have seen growth in both domestic and foreign listed synthetic ETFs, with the main providers being Deutsche Bank and Lyxor (SocGen).
 
The Securities and Futures Commission (SFC), the Hong Kong regulator, has taken strong measures in the last few months to regulate the fast-growing synthetic ETF sector. These include measures to increase the collateral requirements for such ETFs and to enhance transparency for the investors, especially the retail ones.
 
Synthetic ETFs are an important way to get exposure to relatively inaccessible markets such as India and China. The use of synthetic ETFs can provide liquid and efficient means to invest in these two critical Asian markets.
 
Most other Asian markets have not seen a high level of activity in the synthetic ETFs domain. The two synthetic funds in Australia have recently converted to physical ETFs due to rising pressure from the regulator.In markets such as Korea and Japan, physical ETFs have ruled the roost. There is some initial activity in Thailand, Taiwan, and Malaysia, but there is a long way to go before synthetic ETFs become common in these markets.
 
Higher counterparty risk (due to derivative use) and funding liquidity risk are two of the main issues that investors in synthetic ETFs have to contend with. The transfer of tracking error risk to the swap counterparty and the problems that can be created by the use of illiquid collateral are some of the other major concerns of market participants and regulators.