Exchange traded funds track a multitude of assets, but there are a couple of different ways funds track any given market. For instance, an ETF could synthetically or physically replicate a benchmark.
To start off, passively managed physically backed, index-based ETFs hold either all the components of the index or a representative sample to reflect the performance of the underlying benchmark, Jose Garcia Zarate, a passive fund analyst at Morningstar, said.
For instance, something like a S&P 500 ETF would hold the 500 stocks that comprise the S&P 500 index.
On the other hand, synthetic ETFs try to mimic the performance of an index through derivatives such as swaps contracts. A swap is a promise from a counterparty, usually an investment bank, to replicate the performance of the market or index. Consequently, these types of ETF investments are said to be synthetically tracking an index.
For instance, many leveraged and inverse ETFs use swaps and derivatives to achieve their performance objective on a daily basis. [Making Sense of Physical and Synthetic ETFs]
Synthetic ETFs gained popularity, notably in European markets, as proponents argued that the swaps allows investors to more accurately track the underlying index. However, investors have grown increasingly concerned with synthetic ETFs due to greater awareness in counterparty risks raised by their securities lending activities.
Some may ask which type they should choose, but no single type of investment is better than the other. More importantly, investors should use the investment tool they are most comfortable with.
“I think when it comes to ETFs, whether they are synthetically or physically replicated, the main thing to understand for an investor is, what is this ETF giving me in terms of market exposure?” Zarate said in the article. “That’s basically the big – the first thing that you need to do when you are trying to go about choosing an ETF. You need to understand the index.”
In the U.S., synthetic ETFs may refer to leveraged and inverse fund products that utilize swaps in their strategies. About 3% of ETF assets in North America may be considered “synthetic,” whereas over one-third of ETF assets in Europe are synthetic products.
In Europe, there is a growing demand for physically replicated ETFs. Deutsche Asset and Wealth Management has even called physical ETFs the future for replicating mainstream equity indices. [Deutsche Believes ‘Physical’ ETFs Are The Future]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.