Investing in exchange-traded funds (ETFs) is quickly becoming a popular choice for both seasoned investors and beginners. ETFs provide an opportunity to diversify investments, minimise risk, and achieve market returns at a lower cost than mutual funds. ETFs have become increasingly available in Singapore, with synthetic and physical options. Although they may seem similar at first glance, there are essential differences between the two types of ETFs that investors should be aware of. This article will explore the critical distinctions between synthetic and physical ETFs, helping you decide which type best suits your investment goals.
Structure of ETFs
The primary difference between synthetic and physical ETFs lies in their structure. Physical ETFs are backed by the actual underlying assets, such as stocks or bonds, that they track. These funds hold a portfolio of securities that closely mirrors the index they aim to replicate. On the other hand, synthetic ETFs use derivatives, such as swaps or futures contracts, to mimic the index’s performance. Therefore, synthetic ETFs do not hold the underlying assets, making them more complex in structure compared to physical ETFs. Synthetic ETFs are typically managed by a bank or financial institution and involve a counterparty risk for investors.
It is important to note that the structure of ETFs can impact their performance and risk level. Physical ETFs tend to have lower tracking errors, which measure how closely the fund tracks its underlying index, compared to synthetic ETFs because physical ETFs hold the assets they follow, reducing discrepancies between the fund’s performance and the index. However, synthetic ETFs may offer higher flexibility in tracking different indices, as they are not limited to the securities held by physical ETFs.
Another key difference between synthetic and physical ETFs is their tracking error. As mentioned, physical ETFs tend to have lower tracking errors due to their direct ownership of the underlying assets. On the other hand, synthetic ETFs may experience higher tracking errors due to factors such as counterparty risk and management fees. Counterparty risk refers to the potential for the bank or financial institution managing the synthetic ETF to default on its obligations. It could result in discrepancies between the fund’s performance and the index it aims to replicate.
However, it is worth noting that tracking error should not be the sole criterion when choosing between synthetic and physical ETFs. Sometimes, a slightly higher tracking error may be justified if it lowers investors’ costs. It is crucial to consider the overall performance and risk profile of the ETF, in addition to its tracking error.
Cost is another critical factor when choosing between synthetic and physical ETFs. Physical ETFs, which hold the underlying assets, tend to have higher operational costs, such as trading and custodian fees. On the other hand, synthetic ETFs may have lower operating costs but may come with additional fees, such as management and swap fees. These fees are paid to the bank or financial institution managing the synthetic ETF and can impact its overall performance.
It is worth noting that cost should not be the sole determining factor when choosing between synthetic and physical ETFs. While physical ETFs may have higher operational costs, they may also offer other benefits, such as lower tracking error and direct ownership of assets. Investors should consider their investment goals and the overall performance of the ETF when assessing its cost.
Transparency is another key difference between synthetic and physical ETFs. Physical ETFs generally have a more transparent structure as they directly hold the underlying assets. Therefore, investors can easily track which securities the fund holds and how they perform. On the other hand, synthetic ETFs may have a more complex structure and use derivatives, making it harder for investors to understand the fund’s holdings and performance fully.
Traders and investors who prefer high transparency may find physical ETFs more suitable for their needs. However, it is worth noting that using derivatives does not necessarily make synthetic ETFs riskier than physical ETFs. As with any investment, it is essential to thoroughly research and understand the fund’s structure and underlying assets before deciding.
Synthetic and physical ETFs carry different risks that investors should be aware of. Physical ETFs may be subject to market risk, where the value of the underlying assets can fluctuate based on market conditions. They may also face counterparty risk if the custodian or issuer of the ETF defaults. On the other hand, synthetic ETFs carry risks associated with derivatives, such as credit risk and liquidity risk.
Credit risk refers to the potential for a bank or financial institution managing the synthetic ETF to default on its obligations. It could result in losses for investors. Liquidity risk, on the other hand, refers to the ability of an ETF to buy or sell its underlying assets quickly. Synthetic ETFs may face challenges in this area due to their complex structure and reliance on derivatives.