In a stunning financial development, Nigeria’s removal from the S&P Select Frontier index has caught investors off guard, leaving them grappling with unexpected losses. The fallout exposes a hitherto unnoticed flaw in synthetic exchange-traded funds (ETFs), which rely on swap contracts to mimic asset performance, rather than owning the assets outright as physically replicated ETFs do.
Until October 31, Nigerian stocks constituted 4.8% of the £68 million Xtrackers S&P Select Frontier Swap Ucits ETF (DX2Z). However, on November 1, S&P Dow Jones Indices wiped Nigeria off the S&P Select Frontier index tracked by the ETF, reducing this portion of the fund’s portfolio to a value of zero.
Contrastingly, a physically replicated ETF or mutual fund would have been able to liquidate Nigerian holdings and reinvest the proceeds, providing more flexibility. S&P Dow Jones’ decision was based on “significant delays in capital repatriation” for those selling stocks listed in Lagos.
Nigeria’s persistent foreign exchange scarcity, which saw limitations on accessing dollars, has been partially addressed, bringing more liquidity to the FX market. Foreign investors are now showing interest in Nigeria, as the exchange rate aligns more closely with market dynamics.
Liquidity in the Nigerian stock market itself has always been sufficient, suggesting that investors in a physically replicated ETF wouldn’t have faced write-downs to zero, even if there were delays in proceeds from their sales.
Kenneth Lamont, senior fund analyst at Morningstar, commented that “in many cases, the outcome for investors would be similar” for synthetic and physical funds. He cited the example of Russian stocks removed from emerging market benchmarks in 2022 during the Ukraine crisis.
While synthetic ETFs have their advantages, they also come with risks, particularly in volatile markets. Manooj Mistry, COO at HANetf, acknowledged the pros and cons of an ETF’s underlying structure, emphasizing the importance of understanding the associated risks.
This episode highlights the complexities of the ETF landscape, where investors must carefully weigh the trade-offs between different ETF structures and the potential for unexpected market events to impact their investments.
