Exchange traded funds (ETFs) are a type of security that tracks an index. There are two types of ETFs physical and synthetic ETFs. At Moneyfarm we use physical ETFs since they tend to be more liquid and have a lower level of risk meaning we can make your investment more efficient.
Providers of ETFs use either physical or synthetic replication to ensure their ETFs mimic their chosen indices as accurately as possible. Physical ETFs trade the underlying funds of the index, whilst synthetic ETFs use derivatives in an attempt to achieve the same results.
With physical and synthetic ETFs both the risk and the potential reward can vary so investors, or discretionary managers, need to consider the best way of meeting needs in terms of returns and risk tolerance.
A physical ETF works to track the target index by holding all or a representation of the underlying securities that form part of that index. A physical replication involves buying and selling the components of that index; it is labour intensive and may be subject to tracking error, depending on the quality of the ETF. When buying the underlying assets the provider chooses either all of them or an optimised sample.
Many argue that physical ETFs should be split into two different categories and full replication should be distinguished from sampling. Full replication is the most common and is often deemed to be the most reliable. It is not always appropriate in large global markets as the cost of carrying out all of the transactions for full replication may not be in the interest of the portfolio. Sampling reduces these administrative costs but since it does not track the full index the tracking error can increase. Physical ETFs work well for large, liquid markets.
Synthetic ETFs track a particular index by relying on derivatives such as swaps to execute the investment strategy. A swap is a contract between two parties to exchange cash flow over a set period of time, this would be an agreement between the ETF and a counterparty (an investment bank) to pay the ETF the return of the index, minus a fee. A synthetic ETF can track an index without owning any securities.
This swap lowers costs and tracking error but it also introduces counterparty risk. If the bank fails to deliver the promised returns of the index, investors in that ETF could suffer. To manage that risk the counterparty has to post collateral which the ETF provider can claim if there were a default. In theory investors would still receive full market value.
Synthetic ETFs have raised concerns in the market for three reasons: do they deliver the promised returns, do investors understand them and what are they taking as collateral. This collateral may be illiquid or low quality, making it difficult to sell the collateral and pay investors.
Synthetic ETFs can be a good way for investors to gain exposure to hard to access markets. They are useful when the underlying investment is expensive to buy, hold and sell. The reward needs to be balanced with the risk.