But synthetic ETFs don’t work this way often because the markets they track are very hard to physically recreate at a reasonable cost. For example, a market may consist of many small and illiquid securities that are very expensive to trade. Or the complexities of tax, different time zones and local laws make it very difficult to faithfully follow certain countries or efficiently track broad global indices.
Or in the case of commodities it would be inconceivable to take delivery of thousands of cows because you wanted to track livestock.
To circumvent these problems a synthetic ETF uses a total return swap instead of physical holdings to earn the return of its index.
Market overview of synthetic versus physical ETFs
|Asset Class||Physical ETFs
AUM in m GBP
AUM in m GBP
A total return swap is a derivative contract provided by a counterparty such as a global bank or securities dealer or other large financial institution.
The contract means that the counterparty pays the ETF the return of the index it tracks including dividends. In exchange, the counterparty receives a fee and the investment return of collateral posted on behalf of the ETF.
Collateral is used to mitigate the possibility of investors losing out if the counterparty defaults on its obligation to pay. This scenario exposes synthetic ETFs to counterparty risk and it’s important that investors know what that is and how it can be minimised.
Cash invested in the ETF secures a basket of securities that form the ETF’s collateral. If the counterparty defaults then the collateral would be sold and the proceeds used to return investor’s money.
It seems strange but collateral is often held in securities completely unrelated to the market the ETF follows. A FTSE All-Share synthetic ETF may hold some of its collateral in bonds or Japanese equities, for example.
What’s important is that UCITS ETFs are not allowed to expose more than 10% of their Net Asset Value (NAV) to counterparty risk. Any synthetic ETF with the term UCITS ETF in its title is governed by these EU rules.
Many ETF providers apply even stricter criteria to their products and “overcollateralise”. In this case, they ensure that the ETF is protected by collateral worth more than 100% of its NAV.
Physical ETFs may also be subject to counterparty risk if they lend out their securities in order to earn more income.
How a synthetic ETF replicates its index
However, counterparty risk is generally considered to be greater with synthetic ETFs. That has meant a great deal of scrutiny from the media and regulators over the last few years which has led to synthetic ETF providers taking further steps to reduce counterparty risk.
Efforts included spreading the risk by using multiple counterparties instead of just one, increasing the quality of collateral and revaluing it daily to ensure it covers the ETF’s NAV.
Despite the issue of counterparty risk, synthetic ETFs have two main advantages over physical versions.
Firstly, synthetics provide a low cost way to access certain niche markets that would otherwise be off-limits to most investors.
Secondly, they can (although not always) undercut their physical rivals in certain markets with lower Ongoing Charge Figures (OCFs) and tracking error because they avoid the complexities of trading the securities of the index.
You can tell whether an ETF is synthetic or physical by using the screener. Search for the market and asset class you would like to track then, from the overview tab, click on the Distribution policy drop-down on the far right.
Select Replication method and you’ll see that synthetic ETFs are listed as Swap based. All other types are physical ETFs.