Physical vs Synthetic ETFs: Everything You Need to Know

The Exchange Traded Fund (ETF) industry has enjoyed very strong growth in recent years: ETFs are seen to be more transparent, lower cost, and over the medium term better performing than the majority of traditional actively managed mutual funds, whilst being just as safe. This makes them the ideal investment vehicle for long-term investors who want exposure to the upside of capital markets.

The advantages of ETFs are obvious:

1. ETFs usually track the underlying index on a 1:1 basis. Therefore, investors can monitor their performance at any time.
2. Managing these funds does not require a big team of analysts, managers or back-office staff so there is no need for high management fees.
3. Several studies have shown that many active fund managers underperform the selected index which they are benchmarked against.
4. The higher fees of actively managed funds lead to returns being further compressed compared to the index benchmark. As a result, in the medium term actively managed equity funds rarely outperform a passive investment fund.

Security

In terms of security, active and passive investment strategies are very similar. Should the issuer go bankrupt for any reason, the client’s investment in the fund is not lost, as it is kept independent of the financial assets of the issuer in an account at an independent custodian and is thus out of reach of the insolvent investment company.

A few years ago, however, renowned institutions like the International Monetary Fund (IMF), the Bank for International Settlements (BIS) and the Financial Stability Board (FSB) called the good reputation of index funds into question. Slightly exaggeratingly they argued that ETFs could be a threat to the financial system and that some ETFs were too complicated to be traded by private investors as the securities had little correlation with the indices they were tracking. This critique in itself, however, can only be applied to synthetically replicated ETFs.

Physical vs. synthetic

Both physical and synthetic ETFs have their own merits, however, which type may be the more appropriate option depends on how the ETF is constructed.

First, there is the option of physically replicating funds. In the case of 100 percent replication, so-called “full replication”, securities are bought exactly according to their weighting in the underlying index. This is possible for indices which consist of a manageable amount of liquid securities, for example the FTSE. If the index comprises a large amount of securities, for example the MSCI World, which includes 1,600 different stocks, only certain securities are bought; “partial replication”. In this process, securities that are representative of the index are sampled and the selection is optimised by picking securities that have the highest correlation with the underlying index – these securities, however, do not actually have to be part of the underlying index in the first place.

Disadvantages of physically replicating ETFs

1. By default in partial replication, returns could vary from the index over time, this is called the “tracking error”.
2. Full physical replication is more complex to achieve than partial and therefore has higher costs.

In addition to physically replicating ETFs, there are also synthetically replicating ETFs. A synthetically replicating ETF refers to an index fund that tracks an index without buying the underlying assets of the index. Using synthetic ETFs fund managers can replicate an index with little or no tracking error. Some indices, such as certain commodities indices or Emerging Market indices can only be replicated synthetically as the investor cannot buy their underliers physically; an example could be crude oil.

Synthetically replicating ETFs hold margin (also called “collateral”), and enter into a swap (i.e. an exchange transaction) with a counterparty, typically an investment bank, where the counterparty (investment bank) agrees to pay the ETF issuer the performance of the reference index underlying the synthetic ETF and in return the ETF issuer pays the investment bank the performance of their collateral basket.

Through the involvement of a third party, synthetic ETFs carry counterparty risk. To mitigate this risk, UCITS regulations were established to ensure that the exposure to any swap counterparty cannot exceed 10% of the ETF issuing fund’s Net Asset Value (NAV) or in other words the collateral held (security basket) cannot drop below 90% of the NAV. If the market value of the security basket does fall below 90% of the ETF’s NAV, the fund will ask the swap counterparty to pay the prevailing swap value by posting (or delivering) additional securities to top up the security basket (and thereby increase the collateral held) back to 100% of NAV and thereby at least temporarily reducing counterparty risk back to zero. Each of such resets, however, is associated with costs.