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Physical Vs Synthetic ETFs

Similar to traditional mutual funds, exchange traded funds (ETFs) are popular investment vehicles among market participants. One particularly attractive aspect of ETFs is the diversity of offerings, including the equity, debt, commodity and currency asset classes. Even cryptocurrencies such as Bitcoin (BTC) are being considered by financial regulators for future listing. Regardless of an investor's preference, there is more than likely an ETF product available to help satisfy almost any market-related goal.

An ETF is a financial instrument readily accessible on the open market, priced in relation to the value of an underlying asset(s). According to the United States Securities and Exchange Commission (SEC), they are "exchange-traded investment products that must register as an open-end investment company or unit investment trust."[1] ETFs are traded in the same manner as corporate stock offerings, in that participants are free to buy and sell shares throughout each day that associated capital markets are open for business.

While there are many ETF alternatives available to investors, each is categorised as being either synthetic or physical. The distinction is important, as the incorporation of derivative products and exotic asset allocations directly influence the utility of the fund. Risk exposure, potential returns, maturation dates and fees are all directly influenced by the physical or synthetic designation.

What Is A Physical ETF?

Physical ETFs are the most traditional form of an ETF dating back to inception, circa 1990.[2] This type of fund actually acquires and holds the underlying assets or securities on which the ETF's value is based or "tracked." Physical ETFs play an integral role in the global ETF industry, one that has grown from a market capitalisation of US$417 billion in 2005 to US$4.4 trillion in 2017.[3]

The composition of physical ETFs afford interested parties a direct method of engaging a specific asset, security or grouping of either. For instance, if an investor decides to take a long position in the United States equities market, purchasing the Vanguard S&P 500 or the iShares Core S&P 500 ETF may be a viable course of action. Once the purchase is executed, the investor owns shares of the related ETF, which is linked to the performance of the Standard & Poor's 500 (S&P 500). Due to the direct asset/ETF relationship, tracking errors are moderate and costs are less than those of standard mutual funds.

A majority of the ETF trade is conducted via the physical variety. Stocks, bonds and metals (specifically gold) are often viewed as being more secure due to the fund's backing by a hard asset. Fallout from the subprime mortgage debacle and financial crisis of 2008 both promoted the stability of physical ETFs.

What Is A Synthetic ETF?

Introduced to European markets in 2001, synthetic ETFs are the exotic cousin of traditional physical funds. Synthetic ETFs are designed in much the same fashion as physicals, with the primary objective being to track the value of an underlying asset, security or subsequent grouping. However, instead of directly acquiring the assets or securities in question, a synthetic ETF utilises the functionality of derivative products to implement its strategic methodology.

Swaps are the primary derivatives used by synthetic ETFs to achieve their investment objectives. These instruments exist as de facto agreements between the ETF and a designated "counterparty." The counterparty is liable for compensating the fund for any generated returns associated with the underlying asset. In this way, the synthetic ETF is able to track an index or security(s) without actually owning any of the assets involved.

To protect against counterparty default, synthetic ETFs are "collateralised." Essentially, this ensures that a portfolio of securities is held and accessible by the ETF to protect investors in the event of counterparty default. The composition and collateralisation levels of synthetic ETFs can be extremely complex. Credit worthiness, asset value and liquidity are factors that impact collateralisation as well as the binding agreement between the counterparty and ETF.[4]

There are two basic types of synthetic ETFs:[4]

  • Unfunded: Upon the ETF entering into a swap agreement, a "basket" of liquid assets is acquired and posted as collateral by the ETF. The basket is held by the counterparty, with any returns being allocated to the counterparty (typically an investment bank).
  • Funded: Under a funded structure, the basket of assets is acquired in the same fashion. However, the basket is held by an independent custodian instead of the counterparty. In the event of bankruptcy, it may be liquidated with proceeds used to reimburse investors.

Synthetic ETF products have gained popularity in various international locales, including Asia and Europe. However, limited transparency has attracted the attention of regulators around the globe, specifically in the United States. Legislation stemming from the financial crisis of 2008 prohibits financial entities in the U.S. from entering into swap contracts with affiliated parties.[4] This restriction effectively limits the creation of new synthetic funds, as all involved must exist as independent institutions.

Physical Vs Synthetic ETFs: Pros And Cons

The differences between synthetic and physical ETFs are extensive. Ultimately, it is up to the individual to decide which investment vehicle is most suitable. The following are a few considerations pertinent to making a final decision:

  • Tracking Error: The primary objective of both ETFs is to mirror the valuation of the underlying assets or securities. Synthetic ETFs are superior in this area and typically offer lower degrees of tracking variance due to the use of derivatives and complex methodologies.
  • Risk: Physical ETFs hold hard assets, while synthetic funds do not. Due to this discrepancy, participants in synthetic funds assume a greater counterparty risk as bankruptcies or default may facilitate complete loss.
  • Cost: Synthetic ETFs typically offer a reduced fee structure in comparison to physical funds. This is due to the higher operational costs related to asset maintenance and tracking assumed by physical ETFs.

Summary

ETFs offer investors easy and cost-effective ways of gaining exposure to a broad spectrum of markets. From equities indices to commodities, a viable synthetic or physical fund may be readily incorporated into almost any financial strategy. It is up to the individual to perform the necessary due diligence and balance the pros/cons of each type of ETF when selecting an ideal mode of investment.