Abstract
In the wake of the global financial crisis, exchange-traded products (ETPs) have faced to increasing levels of scrutiny. It is understandable that regulators might view such a rapidly expanding and innovative niche within the financial markets with caution; however, such increased regulatory scrutiny could ultimately stifle the development of a product that is in many regards far safer, more transparent, and less costly than many competing investment vehicles. But as with any investment vehicle, there are risks entailed in investing in ETPs, and it is vital that investors understand these risks. Exchange-traded funds (ETFs) using synthetic replication techniques have been at the epicenter of the most recent round of high profile warnings on the risks associated with ETPs. These funds’ added layer of complexity vis-à-vis traditional physical replication funds has led to a good deal of confusion among those investors unfamiliar with the mechanics of swaps—which ultimately provide investors with the return of the reference index within synthetic ETFs. In assessing the risks associated with these structures it is important to address three key questions:1)What is the source of the risk? 2) How are investors being protected against this risk? 3) How are investors being compensated for assuming this risk? This article seeks to answer each of these questions and concludes by providing recommended best practices.
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