Exchange-traded funds (ETFs) are investment vehicles that are made of a number of securities and aim to track the performance of a particular index. Given they provide investors with exposure to a diversified set of assets in a cost-efficient way, ETFs have increasingly gained popularity in recent years.
Two types of ETFs exist: physical ETFs and synthetic ETFs. While physical ETFs trade the physical underlying funds of the index, synthetic ETFs don’t hold the physical securities and use financial 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.
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. In this article, we’ll give you a brief overview of the two types of ETFs so that you fully understand why they are different.
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 to either buy all of them or forms 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. However, 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.
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Synthetic ETFs, on the other hand, do not hold the physical securities and 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 essentially consist in an agreement between the ETF provider and a counterparty (typically an investment bank) to pay the ETF the return of the index, minus a fee.
This swap lowers costs and tracking error but 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 three main concerns in the market: whether they deliver the promised returns, whether investors fully understand them and what they are taking as collateral. Collateral may be illiquid or low quality, making it difficult to sell and pay investors.
Synthetic ETFs can be a good way for investors to gain exposure to markets that are difficult to access. They are useful when the underlying investment is expensive to buy, hold and sell.
However, it is important that investors fully understand how they work, and that rewards are always balanced with risk.