PORTFOLIO POINT: These ‘synthetic’ ETFs offer exposure to important sectors of the Australian market, but there are shortcomings that need to be addressed. Exchange traded funds, or ETFs, have been around for more than a decade and traditionally form part of the passive core of a portfolio by replicating an index such as the ASX 200 or the S&P 500. As the popularity of these instruments has grown, the number of products available has exploded as have the permutations both here and abroad. Last month’s launch of two new sector-specific ETFs from BetaShares give us another reason to pause. Sector-specific ETFs are not new, but the products from BetaShares are structured quite differently. More of that later. These products represent a threat to the traditional funds management sector, which is fighting back with ads saying that ETF users lack conviction and “surrender” when they “reach out to the index”. This is a timely reminder that ETFs can only deliver the “beta” of the market or index they are tracking; however this is where sector-specific ETFs like those offered by BetaShares come into the picture because they allow investors to rotate in and out of sectors as they see fit. We’ll leave it to the market participants to fight the battle between indexing vs active management. For now, let’s look at the products themselves: the BetaShares S&P/ASX 200 Financials Sector ETF (QFN) and the BetaShares S&P/ASX 200 Resources Sector ETF (QRE) Unlike normal ETFs, which buy, hold and rebalance the actual shares that comprise their reference index, BetaShares prominently displays the notion that its funds are “synthetic.” This simply means that they use derivatives to cover their exposure to the index, specifically equity swaps which are hedged by Credit Suisse Securities (Europe) Ltd. Derivatives should be seen no differently to any other financial contract; that is, they require analytical diligence of all their features, terms and risks before any investment decision can be made. The range of issues raised when derivatives are used may be wider than “normal” assets – so specialised analysis may be required – but once properly assessed, the decision to invest or avoid can be simple. The executive team at BetaShares seem to be well-credentialed and experienced in the area. They have gone to significant lengths to build the business and infrastructure required to operate in this complex space. Presumably they have chosen the “synthetic” approach to building their ETFs to obtain the economies of scale that are available when investing through the massive pools of securities and trading positions in place at global investment banks. BetaShares charges fees of 0.39% pa for its ETFs – a relatively low cost for a start-up ETF provider; and one that would have been impossible to deliver (without significant cost) in the early days of this type of business had it used the traditional ETF method of buying/holding and re-balancing physical shares. The BetaShares PDS discloses that it uses equity swaps to track the sectors to which it offers exposure. It then discloses some of the key information relevant to this type of investment, and probably complies with the new ASIC guidelines for disclosure in PDS for structured investments. The PDS does this by telling investors about the extremities of the risks they assume by investing, much the same way doctors tell patients about the risks of dire consequences possible when using prescription medicines. But the PDS doesn’t really help in answering some of the simple and material questions that arise when synthetics/derivatives are used in this type of arrangement. For example, as with all ETFs, BetaShares doesn’t guarantee to track the actual performance of their reference index. Proven players have demonstrated that their approach has negligible “tracking error” and so investors can be highly certain they will get a result very close to the index. But the key terms of the equity swaps used by BetaShares are not disclosed; such as: what is the obligation of the swap counterparty? How closely is it obliged to track the indices? What early termination events exist (how easily can the swap be terminated, potentially to the detriment of the investor)? What law governs the swap contract? What parent company support is provided to the swap counterparty in the event of insolvency of the Credit Suisse group? These are precisely the types of questions that should have been asked by investors in CDOs issued and “backed” by Lehman Brothers (ask the many local Australian councils still trying to get access to their money after the complex insolvency of Lehman – now fighting complex and expensive battles in New York courts). The synthetic approach seems likely to have some considerable tax consequences for Australian investors as well, unfortunately. The tax office takes the view that hedging through swaps will make gains and losses assessable as ordinary income, rather than the capital gains tax treatment that would arise if ordinary shares are held. This is a rather perverse view of the world that disconnects innovation and prudent hedging techniques from widespread use. But in the context of the BetaShares ETF it introduces a tax inefficiency compared to orthodox ETFs hedged with physical shares. Similarly, distributions and franking credits are likely to be lower from the BetaShares ETF than from traditional ETFs. The BetaShares PDS discloses that it may hold some shares in addition to cash and equity swaps, but what they are and what proportion of the overall asset pool of the ETF is not disclosed. BetaShares ETFs are a low-cost way to obtain exposure to important sectors of the Australian market and the provider seems to have built a sophisticated business structure to do this. Unfortunately, the synthetic hedging employed seems in this case to have some significant shortcomings, which will need to be addressed before mainstream acceptance is justified. T.R.