No buy zone

  • Investment Insight
  • 3 minute read

On Russia and synthetic ETFs

Russia’s invasion of Ukraine has triggered an unprecedented backlash. Severe sanctions on Russia have been followed by many Western companies ceasing operations there. Russia’s main equity market, the Moscow Exchange or MOEX, closed for a month and reopened with strict trading restrictions. Russia’s credit markets have also suffered, but so far avoided defaulting on sovereign debt repayments owed to foreign creditors.

This has impacted many exchange traded funds (ETFs) often used by investors as a cheap way to get exposure to foreign equity markets. The halt in trading of Russian securities has led many major index providers to exclude Russia, preferring to isolate it within its own category until further notice.

The risks of investing in Russia are well known but the extent of the economic blowback has surprised many onlookers. Classified as an emerging market (EM), Russia shares many characteristics with other EM peers: equity markets tend to be less mature and occasionally less liquid; confer more political risk, potentially undermining in extremis the enforceability of a contract, for which investors demand a risk premium; and add currency risk and costs, as trading may require non-deliverable forwards (currency trades which can’t be settled in cash but which require forward contracts) across multiple time zones.

Being diversified has protected many. Indeed, even holders of well-known EM ETFs will likely have had no more than 5% of their investment in Russia due to its relative importance compared to more heavyweight peers; in Ukraine it is likely to have been zero.

Not all ETFs are equal, however. Given the difficulties of investing in EM equities, within the Close Tactical Select Passive Funds we have preferred to gain exposure through a synthetic ETF – one which replicates the performance of an EM index without direct exposure to the underlying assets. To understand how this works, it is worth a quick recap of how more traditional – or physical – ETFs work.

Let's get physical, physical

Buying and owning a physical asset is intuitive. Just as an investor buys - and thereby takes part ownership of – company shares or bonds, so an ETF provider buys the shares or bonds of the index it is replicating. But an index’s sheer size may hinder complete replication in this way. As it gets more expensive or complex to purchase so many constituent companies in the right weights, ETF providers may use a technique called optimisation. Particularly common in fixed income markets, bonds are segmented into different risk buckets according to sector, maturity, credit quality, etc., before buying a representative sample of say 20% of all securities. The ETF gives you representative physical ownership.

Synthetic ETFs can track an index without actually owning any of its securities by using derivative agreements - typically with an investment bank - to generate returns. Simplistically put, the ETF ‘swaps’ a basket of assets for an index’s return. This approach may be preferred by fund managers wanting exposure to esoteric, less liquid or trickier to access markets - perhaps commodities where necessarily the investor doesn’t want to take ownership or delivery.

There are pros and cons. Both optimised and physical approaches mean investors have a degree of ownership, voting rights to give effect to their views on Environmental, Social and Governance issues and receive any income (dividends or coupons) directly – all ostensibly positive. But physical replication may mean that you take counterparty risk if the ETF provider has a stock lending policy; in theory, the company borrowing them could go bust.

Swap ya!

Synthetic ETFs theoretically have less tracking error than physical ETFs and performance which is closer to the index, as the swap counterparty has to deliver the market return with no extra costs. Ultimately, though, you do have counterparty risk. UCITS rules stipulate that a fund cannot have more than a 10% exposure to any one counterparty; the twelve approved ETF providers on our panel voluntarily limit this to just 5% or less. Protecting investors in the event of insolvency or default may be a minute tail risk, but it’s one we must plan for.

EM without the EM

Even though the availability of swap-based ETFs has dwindled in recent years, buying the Amundi Asset Management MSCI Emerging Markets ETF across the Close Tactical Select Passive range made sense. This ETF delivers an EM index return via a swap with an underlying basket of mostly US, European, Japanese and Swiss equities, including companies such as Sanofi, Sony and McDonalds.

This is not so intuitive but works: the underlying ETF provider avoids some of the difficulties associated with trading EM equities (time zones, relative illiquidity and immature markets) and also arguably holds better quality assets – which may also report better ESG metrics, too. In this instance, this approach avoids holding any Russian equities in the fund.

Of course, this Amundi ETF is still tracking an EM index and if Russia takes a hit, it will replicate those returns. For this reason, multi-asset portfolios are better equipped to absorb these risks through broader diversification. But this synthetic ETF arguably reduces the potential impact of several other risks at once.

Added value

As custodians of our clients’ wealth, we believe this is a noteworthy example of how we can expertly access markets in ingenious ways. Ours is the pursuit of risk-adjusted returns and ensuring that every decision we make is adding value to the bottom line.

 

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