More exchange-traded funds, or ETFs, are adopting a synthetic replication strategy, so it is unwise to invest in them without fully understanding how they work behind the scenes. This was the message in the Securities & Futures Commission’s latest Dr Wise column published today.

It said the principal objective of an ETF is to track the performance of an underlying index. Some ETFs gain exposure to the underlying index by investing in shares or bonds that make up the index. Investors of these ETFs are exposed to the risks in these shares and bonds.

Synthetic funds

Dr Wise urged investors to look carefully at the “synthetic” nature of ETFs, which do not invest in shares or bonds. Instead, they invest in derivative instruments designed to replicate the performance of those shares or bonds.

For reasons such as access to a restricted market, greater efficiency or cost savings, synthetic ETFs using a synthetic replication strategy invest in over-the-counter derivatives issued by counterparties to gain exposure to the underlying indices.

Investors of synthetic ETFs are therefore exposed to the credit risk of the counterparties who issued the derivatives, in addition to the risks of the shares or bonds the ETFs synthetically replicate.

Some synthetic ETFs diversify the credit risk of counterparties by acquiring financial derivatives from many counterparties. Yet the more counterparties an ETF has, the higher the mathematical probability of the ETF being affected by a counterparty default.

Counterparty risk

Other ETFs only acquire financial derivatives from a few counterparties and require each of them to pledge collateral to reduce the ETFs’ net exposure counterparty risk. In this case, the investor’s counterparty risk exposure is limited to the value not covered by the collateral. Although ETF managers monitor the collateral closely, there is always a risk its market value is reduced substantially.

“Some investments are not as straightforward as you think. Until you thoroughly understand the set-up of an investment product, do not make a commitment,” Dr Wise said.

Information on an ETF’s counterparties and collateral is available from its offering document, which can be downloaded from the Hong Kong Exchanges & Clearing and the ETF issuers’ websites.