Exchange-Traded Funds (ETFs) have become a popular investment vehicle, offering a way to diversify portfolios without the need for direct stock picking. With the increasing accessibility of global markets and investment options, understanding the differences between the two main types of ETFs—synthetic and physical—has become essential for investors.
This article explores the key distinctions between synthetic and physical ETFs and provides insight into what Singaporean investors should know to make informed investment decisions.
Understanding ETFs: A Primer
Before diving into the specifics of synthetic versus physical ETFs, it’s important to understand what ETFs are and how they work. At their core, ETFs are investment funds that hold a collection of assets, such as stocks, bonds, or commodities, and are traded on stock exchanges just like individual securities. T
he main attraction of ETFs is their ability to offer broad market exposure with the convenience of trading on a stock exchange, providing investors with liquidity, diversification, and lower costs compared to traditional mutual funds.
ETFs can generally be classified into two categories: physical and synthetic. Both types aim to track the performance of an underlying index, but they do so in fundamentally different ways. Let’s break down these two types of ETFs in more detail. Click here for more information.
What are Physical ETFs?
A physical ETF directly holds the underlying assets that it tracks. For example, if an investor buys shares in a physical ETF that tracks the performance of the S&P 500, the ETF itself will own the 500 stocks that make up the index. The value of the ETF rises and falls based on the performance of these underlying assets.
The primary benefit of physical ETFs lies in their transparency. Investors can see exactly which assets the ETF holds, which can be reassuring for those who prefer direct ownership.
Furthermore, these ETFs carry lower counterparty risk, as there are no intermediaries involved in holding the actual assets. Physical ETFs are typically more straightforward in terms of structure, making them appealing to those who value simplicity and predictability.
What are Synthetic ETFs?
Unlike physical ETFs, synthetic ETFs do not directly hold the underlying assets. Instead, they use derivatives such as swaps or futures contracts to replicate the performance of an index. Essentially, a synthetic ETF enters into an agreement with a counterparty—often a financial institution—that promises to deliver the performance of the underlying index.
Synthetic ETFs can be appealing because they provide access to markets or assets that might otherwise be difficult or expensive to reach. For example, a synthetic ETF could provide exposure to emerging markets, commodities, or foreign currencies without needing to physically buy and hold the underlying assets. This structure also tends to be more cost-efficient, as there is less need for physical transactions and custody arrangements.
Key Differences Between Synthetic and Physical ETFs
The fundamental differences between synthetic and physical ETFs revolve around how they achieve their goal of tracking an index. Physical ETFs buy and hold the actual assets that constitute the index, while synthetic ETFs use derivatives to mirror the performance. These differences lead to variations in cost, risk, and performance.
When it comes to costs, synthetic ETFs can often be more cost-effective because they don’t require the purchase or storage of physical assets. There are also fewer transaction fees associated with the buying and selling of underlying securities. However, this cost-saving may be offset by other factors, such as higher management fees or the need to account for the risks involved in using derivatives.
Tracking error is another critical consideration. Tracking error refers to the difference between the ETF’s performance and the performance of the index it tracks. Because synthetic ETFs rely on derivatives and counterparty agreements, they tend to experience higher tracking errors. This can make them less precise than physical ETFs in terms of mirroring the performance of the underlying index.
Advantages of Synthetic ETFs
For some investors, synthetic ETFs present a number of advantages. One of the most significant benefits is cost efficiency. Synthetic ETFs tend to have lower fees compared to their physical counterparts, primarily because they avoid the operational costs of purchasing and holding the actual assets. The use of derivatives can also streamline the process of rebalancing a portfolio, making synthetic ETFs attractive for investors looking for a more hands-off approach.
Synthetic ETFs also provide access to markets that might be difficult or expensive to access otherwise. For example, they can enable exposure to illiquid or less accessible asset classes, such as certain commodities, currencies, or markets with high entry barriers. By using derivatives, synthetic ETFs can bypass the complexity and cost of physically acquiring these assets, making them a more efficient option for international diversification.
Conclusion
Both synthetic and physical ETFs have distinct advantages and potential drawbacks, and the choice between the two depends on individual investment goals, risk tolerance, and market conditions.
Physical ETFs are ideal for investors seeking transparency, direct ownership of assets, and lower counterparty risk, while synthetic ETFs offer cost efficiency, access to hard-to-reach markets, and greater flexibility. For Singaporean investors, understanding these differences is crucial for building a diversified, efficient portfolio.
