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Investors in ‘synthetic’ ETF suffered losses after Nigeria was removed from the index-Report 

Investors in a derivative-linked “synthetic” exchange-traded fund (ETF) have suffered losses after Nigeria was removed from its underlying index.

This highlights a potential weakness of the synthetic ETF structure, which relies on swap contracts with counterparties to replicate the performance of underlying assets, rather than physically owning the assets themselves.

According to a report from the Financial Times, the £68 million Xtrackers S&P Select Frontier Swap Ucits ETF (DX2Z) had 4.8% of its portfolio allocated to Nigerian stocks until October 31.

When S&P Dow Jones Indices removed Nigeria from the S&P Select Frontier index on November 1 at a “zero-price,” this portion of the fund’s portfolio was written down to zero.

In contrast, a physical index-tracking ETF or mutual fund would theoretically have been able to sell its Nigerian holdings and reinvest the proceeds back into the fund.

S&P Dow Jones removed Nigeria from the Select Frontier index due to “significant delays in capital repatriation” for investors selling Lagos-listed stocks.

Nigeria has long struggled with foreign exchange scarcity, with even importers of many goods barred from accessing dollars at the official exchange rate until the current president, Bola Tinubu, took over in May.

The central bank has since adopted a “willing-buyer and willing-seller” model, which allows the Nigerian naira to float more freely and the exchange rate to be determined by market forces.

However, Charlie Robertson, head of macro strategy at FIM Partners, an asset manager specializing in emerging and frontier markets, noted that investors faced barriers in repatriating money under the old regime.

Given that liquidity in the Nigerian stock market itself has always been adequate, that suggests investors in a physically replicated ETF would not have seen their Nigerian holdings marked down to zero, even if there had been a delay in receiving the proceeds from their sale.

A number of physical ETFs, such as the iShares Frontier and Select EM ETF (FM), and VanEck Africa Index ETF (AFK), happily hold fully valued Nigerian stocks in their portfolios.

However, Lamont said that “in many cases, the outcome for investors would be similar” between synthetic and physical funds. He cited the example of Russian stocks being removed from emerging market benchmarks in 2022 when the country launched its full-scale invasion of Ukraine.

Michael Mohr, global head of Xtracker products, struck a similar note.

Mohr said he had seen structural market risks, as in Nigeria’s case, or geopolitical risks, as with Russia, blow a hole in synthetic ETFs twice in his 25-year career, with both occurring in the past two years.

Physical ETFs do not necessarily fare better in these episodes, though, he argued.

Synthetic ETFs account for €26 billion of the €147 billion ETF book of Xtrackers, the ETF arm of DWS, Germany’s largest asset manager, which is majority-owned by Deutsche Bank.

Synthetic ETFs account for €26 billion of the €147 billion ETF book of Xtrackers, the ETF arm of DWS, Germany’s largest asset manager, which is majority-owned by Deutsche Bank.

In total, they account for €169bn, or 11%, of Europe’s €1.5 trillion ETF market, according to Morningstar Direct, down from a peak of 17.6% in 2017.

Mohr argued that swap-based products can offer advantages, particularly in emerging markets where a fund manager would otherwise have to open securities accounts in every country in which it invests and will often face restrictions around limits on foreign ownership, a problem that can be offloaded to the swap counterparty instead.

Manoj Mistry, chief operating officer at white-label ETF provider HANetf, also believed there were pros and cons to an ETF’s underlying structure.

Mistry launched Xtrackers during his time as co-head of index investing at DWS, including rolling out the S&P Select Frontier Swap Ucits ETF in 2008 as the first such vehicle in the world.