What are physical and synthetic ETFs?


Typically, after you've determined the benchmark you want your client's investment to track, your next decision is how to track that benchmark, which leads us to a discussion about the differences between physical and synthetic ETFs.


Physical ETFs

In a nutshell, physical ETFs attempt to track their target indexes by holding all, or a representative sample, of the underlying securities that make up the index. For example, if you invest in an S&P 500 ETF, you own each of the 500 securities represented in the S&P 500 Index, or some subset of them. Physical replication is reasonably straightforward and transparent. Nearly all ETF products in the United States are physical ETFs.

Physical ETFs have demonstrated a strong capability to provide low-cost access—with low tracking error—to many broad-based indexes, suggesting that investors often may not need to take on the increased counterparty risk of synthetic ETFs.


Synthetic ETFs

Though some synthetic ETFs are available in the United States, they are most popular in Europe, where they were introduced in 2001. Like their physical cousins, synthetic ETFs are designed to track a particular index. However, the synthetic ETF replication process is quite different. Instead of physically holding each of the securities in its index, a synthetic ETF relies on derivatives such as swaps to execute its investment strategy.

These derivative vehicles are agreements between the ETF and a counterparty—usually an investment bank—to pay the ETF the return of its index. In essence, a synthetic ETF can track an index without actually owning any of its securities.

Because they don't physically hold the securities in which they invest, synthetic ETFs can provide a competitive offering for investors seeking to invest in harder-to-access markets, less liquid benchmarks, or other difficult-to-implement strategies that would otherwise be very costly and difficult for physical ETFs to track.

Counterparty risk

The chief risk of synthetic ETFs is counterparty risk. Essentially, synthetic ETF investors trust that the total-return swap provider will carry through on its obligation to pay the agreed-upon index return. If that does not happen, investors risk incurring a loss. The key risk mitigator in the event of a counterparty default is collateral.

Unique types of synthetic ETFs—inverse and leveraged | more

Inverse and leveraged ETFs are two types of synthetic ETFs that are common in the United States. Inverse ETFs attempt to deliver the opposite, or inverse, of the benchmarks they track. An inverse ETF is expected to deliver a positive return on a day when its index goes down and a negative return when the index goes up.

Leveraged ETFs attempt to deliver multiples of the returns of the benchmarks they track. Such an ETF might be designed to return two or three times the value of the daily benchmark increase or, conversely, two or three times the market's decline.

It's important to remember that most inverse and leveraged ETFs are designed to achieve their objectives on a daily basis. Be sure your clients understand that when held for more than a day, these ETFs can produce returns that differ dramatically from their benchmark returns.

In many cases, especially when it comes to tracking less liquid, more exotic indexes, synthetic replication helps to reduce, but does not completely eliminate, tracking error. For instance, swap spreads (the cost of having investment banks provide an index’s return) create tracking differences.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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