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How to tell if your ETF is physical or synthetic
Some ETFs have physical underlying holdings, which is safer for the investor, whereas some are derivative instruments where you take the credit risk of the underlying issuer (eg UBS, Citibank). Is there an easy way to differentiate between the two types; for instance, is it clearly stated on their factsheet or is there some way to tell from their identifying code?
Reporter Yoosof Farah replies:
You are correct to say there are two types of ETF – physical ones and synthetic ones.
Physical ETFs buy the underlying assets to physically replicate the index they are tracking.
A commonly used method of replicating an index is full replication, where for example an ETF tracking the FTSE 100 would buy shares in all the companies in the index.
But where this is a bit difficult, for example with an ETF tracking the MSCI World Index and its 1,000-plus constituents, ETFs will a technique called ‘optimisation’, whereby they will obtain the desired exposure by matching things like sector and country weights, the dividend yield, etc, without needing to buy all of
the stocks in the index.
Synthetic ETFs on the other hand use complex financial tools like derivatives to replicate the returns of the index, without actually buying the holdings at all.
These are more commonly used for leveraged ETFs, more illiquid stock markets like some emerging markets, and ETFs linked to commodities, where investors wouldn’t actually want to take physical delivery of things like oil for example.
There are advantages and disadvantages to both types. Synthetic ETFs tend to have a lower tracking error, meaning their returns stick closer to the index they’re tracking. Yet there is counterparty risk, namely the risk of the counterparty going bust and not being able to fulfil its commitments, which would wipe out the ETF’s return.
The best way to see if an ETF is physical or synthetic is to look at the ETF’s literature, namely the factsheet and key investor information document (KIID).
On the factsheet, this information should be detailed in the fund’s fact box, where among other details like cost, benchmark and rebalancing frequency, it should also mention ‘product structure’, and this will say whether the ETF is physical or synthetic.
More detail on this will be given in the KIID, on the first page under a heading like ‘Objectives and Investment Policy’. For example, in the KIID for iShares Core FTSE 100 (ISF), which is a physical ETF, it says: ‘The fund intends to replicate the index by holding the equity securities, which make up the index, in similar proportions to it.’
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