Extra due diligence needed for synthetic ESG ETFs

The current collateral held by the ETF might not meet the expectations of investors

Sustainability-oriented investors should expect to find some unexpected holdings in their portfolio when they choose products with a swap-based (synthetic) index replication approach.

While index products with a full replication approach hold normally only the constituents of their respective index, the portfolio of a synthetic product is built with a swap that replicates the risk/return profile of the respective index and the so-called collateral. The securities held as collateral are often chosen based on their liquidity and transaction costs, as this helps to minimise the costs of managing the product.

Even as these synthetic ETFs may technically fulfill the requirements to be classified under article 8 or 9 of the Sustainable Finance Disclosure Regulation (SFDR) given the nature and the economic exposure of the tracked index, the current collateral held by the ETF might not meet the expectations of investors since they may come from industries or sectors which are not considered sustainable.

This means sustainability-oriented investors who want to choose a product with synthetic replication need to add an extra layer of due diligence to their product selection process. Since they need to review the portfolio holdings of respective products on an ongoing basis, as the collateral can change over time.

On the other hand, investors who chose a product that uses a full replication approach to replicate the index would only need to perform due diligence of the index to ensure that the index methodology and the resulting index constituents meet their expectations.

More generally, sustainability-oriented investors have always had to do a proper due diligence on an index and product level when they want to buy a mutual fund or ETF with a sustainable or ESG-related investment objective. This is the only way to understand which criteria are used to determine the constituents of the index.

Nevertheless, synthetic products require an extra level of analysis as investors need to make sure that the holdings in the collateral are also in line with their expectations. Investors can’t make any assumptions about the ESG credentials and their outcome on a portfolio level from the product name and/or the SFDR article assignment.