What Are Synthetic ETFs and How Do They Differ from Physical ETFs?

ETFs have become a cornerstone of modern investing, providing investors with a simple way to diversify their portfolios. However, not all ETFs are the same. There are two primary types: physical ETFs and synthetic ETFs. Understanding the distinction between these two categories is crucial for anyone involved in ETF trading. While both types aim to replicate the performance of a specific index, they do so in different ways, each with its own set of risks and benefits.

Physical ETFs are the more traditional type of exchange-traded fund. They achieve their objective by directly holding the assets that make up the index they track. For example, a physical ETF that tracks the S&P 500 will buy shares of all 500 companies in that index. This straightforward approach offers transparency and a clear understanding of what the fund owns at any given time. For investors, this can be reassuring, as they know their ETF is backed by real assets. In Trading ETFs, many investors prefer physical ETFs for their simplicity and transparency.

Image Source: Pixabay

In contrast, synthetic ETFs take a different approach to achieving their investment goals. Instead of holding the underlying assets, synthetic ETFs use derivatives, such as swaps, to replicate the performance of an index. In this case, the ETF doesn’t actually own the stocks or bonds of the index it tracks but enters into an agreement with a counterparty—often a bank or financial institution—to deliver the return of the index. This method allows synthetic ETFs to efficiently track complex indices or hard-to-access markets. However, because they rely on financial agreements, they come with additional risks, such as counterparty risk. Trading ETFs with synthetic ETFs can offer certain advantages, but it requires a deeper understanding of these underlying risks.

One of the key benefits of synthetic ETFs is their ability to track indices that may be difficult or expensive to replicate physically. For example, emerging markets or commodities are often challenging for physical ETFs to replicate accurately due to liquidity issues or the costs of holding the actual assets. Synthetic ETFs solve this problem by using derivatives, making it easier and more cost-effective to track these indices. For investors seeking exposure to niche markets, synthetic ETFs provide an attractive option. In ETF trading, this can open up opportunities that might otherwise be out of reach.

Despite their advantages, synthetic ETFs carry additional risks compared to their physical counterparts. The most significant risk is counterparty risk, which refers to the possibility that the institution providing the return on the index could default on its obligations. While regulations are in place to limit this risk, it’s not entirely eliminated. Investors involved in ETF trading with synthetic ETFs should be aware that they are relying on the financial health of the counterparty to deliver the promised returns. While the chances of a large financial institution defaulting may be small, it’s a risk that doesn’t exist with physical ETFs, where the fund owns the actual assets.

Another difference between synthetic and physical ETFs is their potential for tracking error. Physical ETFs may experience slight deviations from the index they aim to replicate due to factors like transaction costs or liquidity issues. Synthetic ETFs, on the other hand, tend to have lower tracking errors because the derivatives they use are designed to deliver the exact performance of the index. For those involved in Trading ETFs, minimizing tracking error can be a crucial consideration, making synthetic ETFs appealing for certain strategies.

In terms of costs, synthetic ETFs can sometimes be more cost-effective than physical ETFs. Because they don’t need to buy and hold the actual assets, synthetic ETFs may incur lower operational costs. This can lead to lower expense ratios for investors, making Trading ETFs with synthetic ETFs an efficient way to gain exposure to certain markets. However, the lower costs should always be weighed against the additional risks involved in using derivatives.