Physical or synthetic ETFs: should you care?

The distinction between buying a physical or synthetic ETF is not one most retail investors make or are even aware of. However, for professional fund managers, choosing between the two is an important consideration when building a global, multi-asset portfolio.

Let’s get physical, physical?

Just as a retail investor buys shares or bonds, an ETF provider buys those of the index it is replicating. Where the number of constituent companies in an index is large (the MSCI World Index or Russell 2000 have over 1,000 constituents), ETF providers may use a technique called ‘optimisation’. The idea behind this strategy is to obtain the desired index exposure without buying all the constituent companies, but instead matching the risk characteristics such as sector weights, country weights (in the case of regional indices) and dividend yield.

Swap ya! Synthetic ETFs

Synthetic ETFs track an index without actually owning any of its securities by using derivative agreements² – typically with an investment bank – to generate returns. Simply put, it can ‘swap’ the returns of a basket of assets for the return of an index (see image below).

This approach may be preferred by fund managers wanting exposure to less liquid or trickier to access markets - perhaps emerging markets (EM) or commodities for example - where investors do not want to take physical delivery of the oil, the hog or the soybeans.

The pros and cons

Both physical and synthetic approaches mean that investors have a degree of ownership, including voting rights, and receive any income (dividends or coupons) directly – all positive attributes.

Synthetic ETFs theoretically have a lower tracking error than their physical counterparts, generally meaning the ETF’s performance is closer to that of the index, as the swap counterparty has to deliver the market return exactly.

‘Counterparty risk’ (the risk of a counterparty going bankrupt and therefore not being able to fulfil its commitments) is present in both physical and synthetic ETFs. Physical ETFs have the potential to be exposed to ‘counterparty risk’ if the ETF provider engages in securities lending. With synthetic ETFs, you are unavoidably taking on ‘counterparty risk’ with the swap provider.

UCITS rules state that a fund cannot have more than 10% exposure to a single counterparty, and the ETF providers on our panel that offer swap-based ETFs limit this further to 5% or below. Protecting clients in the event of insolvency or default may be an unlikely risk, but it is one we plan for.

The availability of synthetic ETFs has dwindled in recent years, but buying one can, on occasion, solve several issues at once. The Amundi Asset Management MSCI Emerging Markets ETF is held across the Close Tactical Select Passive (TSP) fund range. This swap-based ETF holds a basket of mostly European and Japanese equities and swaps the returns of this basket for the index returns.

There are three key reasons to use a synthetic ETF for this exposure:

1. It is very transparent in terms of what ‘counterparty risk’ is present (the swap is with BNP Paribas) and what the basket consists of.
2. The securities held in this ETF tend to be more liquid than their EM peers and trade in markets which are more mature (i.e. gaining exposure to MSCI EM by buying companies such as Sanofi, Roche and SAP rather than more obscure EM holdings).
3. If the ETF were to become insolvent, we would avoid the difficulty of liquidating positions across various markets with trading hours outside those of the UK’s (i.e. stock exchanges open here at 0800 GMT which is 1600 in China, when Chinese stock exchanges close for the day. Over 30% of the MSCI EM index is made up of Chinese stocks, so we are avoiding this liquidity risk).

Why Close Tactical Select Passive?

We believe this is a great example of why it’s important to actively research even the passive portion of your clients’ portfolios. Ours is the pursuit of risk-adjusted returns and ensuring that every decision we make is adding value to the bottom line.

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Important information
This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients.  The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.