Synthetic ETF Investors Suffer Losses as Nigeria is Dropped from Underlying Index
Investors in a derivative-linked “synthetic” exchange-traded fund (ETF) have faced financial losses as Nigeria was removed from its underlying index, exposing potential vulnerabilities in this investment structure. The Financial Times reported that Nigerian stocks previously accounted for 4.8% of the £68 million Xtrackers S&P Select Frontier Swap UCITS ETF (DX2Z) until October 31.
On November 1, S&P Dow Jones Indices unexpectedly stripped Nigeria from the S&P Select Frontier index, resulting in the fund’s portfolio writing down the value of its Nigerian holdings to zero. This move impacted investors in the synthetic ETF, which relies on swap contracts to replicate the performance of underlying assets rather than direct ownership.
The removal of Nigeria from the index was attributed to “significant delays in capital repatriation” for those selling Lagos-listed stocks. The country has grappled with foreign exchange scarcity, with importers previously unable to access dollars at the official exchange rate until May when President Bola Tinubu took office.
The Financial Times report suggests that a physically replicated ETF or mutual fund would have had more flexibility in handling such events, as they could have sold the Nigerian holdings and reinvested the proceeds.
Kenneth Lamont, a senior fund analyst for passive strategies at Morningstar, pointed out that this situation could be viewed as a structural disadvantage of swap-based exposures compared to physically managed funds. He explained that the latter provides greater flexibility to navigate such occurrences.
Despite this setback, it’s worth noting that both synthetic and physical funds can face similar outcomes in cases of geopolitical or structural risks. Michael Mohr, the global head of Xtracker products, highlighted that these incidents can impact both types of ETFs. Synthetic ETFs currently account for a significant portion of Europe’s ETF market.
In the case of Nigeria’s removal from the index, the synthetic ETF structure came with the disadvantage of experiencing a complete write-down of the Nigerian holdings. Synthetic ETFs offer advantages in terms of tracking accuracy and performance in specific market conditions, but they also carry counterparty risk. Investors are encouraged to weigh the risks against the benefits when choosing between synthetic and physically replicated ETFs.
Manooj Mistry, the chief operating officer at HANetf, noted that while synthetic ETFs can provide excellent tracking profiles, there are inherent risks in the event of extreme market scenarios. Frontier markets, in particular, can pose unique challenges for investors, and awareness of potential risks is crucial when entering such markets.
The incident with the Xtrackers S&P Select Frontier Swap UCITS ETF highlights the complexities of investing in synthetic ETFs and the need for investors to carefully consider their choice of investment vehicles.