Physical vs synthetic ETFs

A physical ETF and a synthetic ETF are two different ways that exchange-traded funds (ETFs) can track the performance of an underlying index or asset.

An ETF, or exchange-traded fund, tracks an asset or a basket of assets following a predetermined strategy. There are two ways the fund can track the asset(s): via physical replication or synthetic replication.

Read on to find out what these mean and which type of ETF may be suited for your needs.

synthetic etf vs physical etf

What is a physical ETF?

A physical ETF is designed to mimic the performance of a specific index or asset by actually holding the same or a very similar portfolio of the underlying assets. There are three types:

Full replication

A physical ETF is an exchange-traded fund that closely tracks the performance of an underlying index or asset by holding all, or nearly all, of the actual assets that make up that index. For example, if the ETF aims to track a stock market index, it will buy and hold the individual stocks in that index in the same proportion as they are in the index. Similarly, if it's tracking a bond index, it will hold a portfolio of bonds that closely matches the index composition.

Full physical replication provides a high degree of transparency because investors can easily see the list of assets held by the ETF. This transparency helps investors understand what they are investing in. Since it holds the actual assets, a well-managed full physical replication ETF should closely mirror the performance of the underlying index, resulting in minimal tracking error. Tracking error is the difference between the ETF's returns and the returns of the index it's tracking.

Physical ETFs tend to be more liquid and straightforward, making them suitable for investors who want exposure to traditional and well-established asset classes like stocks, bonds, or commodities.

The management fees and expenses associated with full physical replication ETFs are generally transparent and can be lower compared to other ETF structures.

Replication by sampling

Replication by sampling is a type of exchange-traded fund (ETF) that aims to track the performance of an underlying index or asset, but it does not hold all the individual securities or assets within that index. Instead, it uses a sampling or optimisation technique to replicate the index's returns with a smaller selection of holdings.

Sampling physical ETFs are often used when replicating an entire index with all of its constituents would be impractical, costly, or inefficient. These ETFs are more common in cases where the index contains a large number of securities, many of which are illiquid or hard to access.

However, it's important to note that sampling introduces some level of tracking error. The performance of a sampling physical ETF may not perfectly match that of the target index due to the selectivity of the holdings. Investors should be aware of this tracking error and consider it when evaluating the ETF's suitability for their investment goals.

Replication by optimisation

“Sampling by replication” and “sampling by optimisation” are terms often used interchangeably to describe the same approach employed by certain exchange-traded funds (ETFs) to replicate the performance of an underlying index. Both methods involve selecting a subset of holdings from the index rather than owning all of them. However, there can be slight differences in how these terms are used.

“Sampling by optimisation” is a similar concept, but it often implies a more sophisticated or data-driven approach. ETFs using optimisation techniques may use mathematical models and algorithms to select and weigh the subset of assets that will be included in the fund's portfolio. These models aim to optimise the portfolio's performance with the least tracking error relative to the index, considering factors like historical returns, volatility, and correlation between assets.

Physical replication methods ETFs

In essence, both sampling by replication and sampling by optimisation involve the ETF manager carefully choosing a subset of holdings to mimic the performance of the index, but the latter term often suggests a more data-driven and systematic approach.

The type of ETF must be announced clearly, such as in the following example:

Global X litium

If we compare the assets of this ETF and those of the index, we will see that they are the same:

Global X Lithium & Battery Tech ETF (LIT)

composition ETF Litium

Solactive Global Lithium Index

Composition Solactive index

Synthetic ETFs

Synthetic ETFs are more complex than physical ETFs. They have the same goal of replicating a benchmark, but they do not acquire the underlying assets of the index, instead, they use financial derivatives, specifically swaps, to achieve this goal.

Here's how it works: the ETF enters into a swap contract with one or multiple counterparts, usually investment banks. In this swap agreement, the counterpart commits to paying the index's return before accounting for commissions and expenses. Consequently, the issuer of the ETF shifts the tracking error risk to this third party.

This method proves advantageous for ETFs tracking very broad, illiquid, shallow markets, or employing more complex investment strategies. It helps reduce many of the operational expenses. For instance, it is beneficial for tracking emerging markets, niche themes, and markets that are challenging or costly to replicate physically, such as volatility, and inverse strategies.

However, it's important to note that this advantage comes with added counterparty risk. In contrast, physical replication ETFs may also involve counterparty risk when engaging in securities lending. To mitigate this risk, they typically require borrowers to provide collateral, often in the form of investment-grade fixed-income securities, exceeding the value of the borrowed assets. This collateral is evaluated daily at market prices and is held by an independent custodian.

Example of a synthetic/swap ETF

Here is how a hypothetical fund, such as XYZ Synthetic FTSE 100 ETF would work.

The ETF issuer enters into an agreement with a counterparty (often a bank or financial institution). This counterparty agrees to provide the returns of the FTSE 100 Index to the ETF.

To mitigate risk, the counterparty may require the ETF issuer to provide collateral. In this case, let's say the ETF issuer deposits $10 million in cash as collateral with the counterparty.

The ETF issuer and the counterparty enter into a total return swap agreement. Under this agreement, the counterparty agrees to pay the ETF issuer the total return of the FTSE 100 Index.

The counterparty holds the $10 million collateral provided by the ETF issuer to secure the swap agreement. This collateral is maintained to cover potential losses in case the counterparty fails to meet its obligations.

As time passes, the FTSE 100 Index goes through changes in value based on the performance of the underlying stocks.

Periodically, the counterparty calculates the total return of the FTSE 100 Index, including dividends and capital gains. If the index has gained in value, the counterparty makes a payment to the ETF issuer. If the index has lost value, the ETF issuer pays the counterparty.

Read more about ETFs

Summary physical vs synthetic ETFs

In conclusion, physical and synthetic ETFs represent two distinct approaches to achieving the same fundamental goal: providing investors with exposure to a specific index or asset class. Each approach has its advantages and considerations, and the choice between them depends on various factors, including investment objectives, and asset class complexity.

FAQs

Do synthetic ETFs have advantages over physical ETFs?

Synthetic ETFs can be more efficient for tracking complex or less liquid asset classes where acquiring and holding the actual assets may be challenging or costly. They may also offer cost efficiencies. However, they come with counterparty risk, which investors should consider.

How can I assess the counterparty risk of a synthetic ETF?

o assess counterparty risk, investors should review the ETF's prospectus and documentation to understand the counterparty arrangements, collateral requirements, and creditworthiness of the financial institution. Diversification of counterparties and collateral management practices can help mitigate this risk.

Can I find out which replication method an ETF uses?

Yes, ETF issuers are required to disclose their replication method in the fund's prospectus and documentation. Look for sections that describe the ETF's investment strategy or methodology to find this information.

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