Updated: Korea Investment to debut synthetic ETF

Fund manager Korea Investment Management (KIM) is preparing to launch the first synthetic exchange-traded fund in Korea in collaboration with Deutsche Bank arm db X-trackers.

Market sources say the fund could launch by the end of this month. KIM officials confirmed plans to introduce an ETF based on a swap with a local counterparty. Later this year it intends to launch an "ETF of ETFs" based on international products managed by db X-tracker, a unit of Deutsche Bank. Officials there declined to comment.

Samsung Asset Management is also preparing to introduce a swaps-based ETF, but its product design is not as ready. In any event, regulators are said to favour giving KIM the first-mover advantage because of Samsung AM’s existing dominance in the Korean ETF space, say people familiar with the situation – although KIM officials dispute this, noting they have been doing the legal and operational preparatory work for over one year.

Samsung manages about $8 billion in exchange-traded products, representing 55% of the Korean market. Samsung AM officials declined to comment.

The move to introduce synthetic ETFs, which rely on swaps with a bank counterparty to create an index-like exposure, rather than on in-kind baskets of underlying index constituents, is being pushed by the Korea Stock Exchange (KRX) and the Financial Supervisory Service (FSS), which are keen to diversify the ETF space.

Executives in the ETF industry in Seoul say the KRX has shifted its strategy from simply listing lots of products – which has resulted in quite a few cookie-cutter products – to broadening the product offering available to local investors.

A synthetic product is not expected to be a best seller, but it is a step on the path to a more sophisticated market. It will also provide additional shorting tools or shorting liquidity to the nascent onshore hedge-fund industry.

Such products are likely to only appeal to retail investors, as local institutions have rules or follow market practices that frown upon use of over-the-counter derivatives. Institutions would also be concerned about the size of an investment type, the nature of fellow investors and a product’s liquidity.

Retail investors, on the other hand, have been enthusiastic traders of ETFs. Samsung Asset Management’s dominance of the leveraged and inverse ETF space, which enables retail investors to day-trade indices, is the key to its success in the ETF field.

So any uptake of synthetic products is likely to be from retail investors, “even though retail investors barely understand cash ETFs", notes one fund executive in Seoul with an ETF brand.

Swaps-based ETFs provide tighter tracking error but incur additional fees, as they involve more than just paying the ETF fund manager and its custodian, but also a swaps dealer and overseas administration and custody fees. This will be another barrier to attracting investors.

The overseas aspect is important because there are too few stocks in Korea that support OTC derivatives. Therefore KIM is expected to debut with an overseas ETF product, say rival asset managers.

Synthetic ETFs are primarily a European product, each one backed by an affiliated broker-dealer (ie, Deutsche Bank tends to make markets for db X-tracker products). The US industry is mainly cash based. Korean fund industry executives say their market is going to be a hybrid, at least for now, without exclusive relationships between market makers and fund managers. Whether that creates enough of a bid/offer to keep tracking error accurate remains to be seen – as does the degree to which local investors embrace the idea of synthetic ETFs.