When you invest in ETFs, you have to choose the best funds for you among thousands. They differ on many aspects, including the replication of their underlying index: physical replication or synthetic replication. But what is the difference between the two? And most importantly, which should you invest in? Let's find out.
What's an ETF?
An ETF (or exchange-trade fund) is a collection of tens, hundreds, or sometimes thousands of stocks or bonds. This spreading is one of the most attractive aspects of owning an ETF compared to individual stocks and bonds. By investing in a single ETF, you become invested in thousands of companies in one go. The majority of ETFs are designed to track a market index, which is why they're sometimes called "trackers".
A popular one is the S&P 500 which stands for the Standard & Poor’s 500 index. As the name suggests, it seeks to track the performance of a composition of the 500 largest American companies. Through an S&P 500 ETF, you get exposure to a large section of the US economy as it covers 80% of the total American market capitalisation.
The style of investing based on indexes is called index investing (also called passive investing), as you choose to ignore day-to-day price changes knowing that the market will keep growing. You typically purchase and hold your investments for the long term. And the data shows that this strategy is most likely to give you the highest return.
ETFs can differ on many aspects, but one is how they replicate the underlying index. This is where the difference between physical and synthetic ETFs comes in. Let's dive deeper!
What's a physical ETF?
A physical ETF tracks the underlying index by buying all of the stocks in the index, according to the weights dictated by the index. So a physical ETF tracking the S&P 500 literally buys each of the stocks in the S&P 500.
Some physical ETFs buy only a limited number of stocks in the index. This is called "sampling". The reason is that some indexes are too large, or the underlying markets are too illiquid, to own every single stock. So the ETF invests in an optimal sample of stocks that sufficiently represents the index.
What's a synthetic ETF?
A synthetic ETF does not hold the underlying stocks that it is designed to track. Instead, it uses derivatives such as swaps, futures, or options to replicate the performance of its underlying index. The ETF provider will enter into a contract with a counterparty, typically an investment bank, to create a synthetic replica of the underlying index. The counterparty will then provide the ETF with a return based on the performance of the index.
These contracts are usually in the form of swaps. When the performance of the index is higher than that of the assets physically held by the manager of the ETF, the counterparty must pay the difference in performance to the fund provider. In effect, the fund manager buys more physical assets. However, if the performance of the index is lower than that of the physical assets, the fund manager owes money to the counterparty. It therefore sells physical assets and pays the swap holder.
Differences between a physical and synthetic ETF
There are several differences to take into account.
Counterparty risk for synthetic ETFs
The main issue with synthetic replication is that the returns depend on the counterparty being able to honour its commitment. This carries a risk that physically replicated ETFs don't have. After all, it's uncertain what happens were the counterparty fail to meet its commitment. Even the European Central Bank (ECB) has communicated on this risk of synthetic ETFs.
Synthetic ETFs are more complex and less transparent
The ECB also mentioned the lack of transparency of synthetic ETFs, because fund providers don't always fully disclose the swaps and other derivatives that they use. On top of that, these are complicated financial instruments for most to understand, especially if you're not a finance professional.
Synthetic ETFs can be cheaper
The cost of a swap can be cheaper than the transaction costs for buying stocks. So one advantage of synthetic ETFs is that they are often cheaper than their physically replicated counterparts.
Synthetic ETFs have a lower tracking error
No ETF can perfectly mimic the performance of the underlying index. The difference is called the tracking error. Synthetic ETFs usually have a lower tracking error because the returns are financially engineered, rather than coming from the physical ownership of the stocks.
How to tell them apart
The best way to check if an ETF is physical or synthetic is to review the fund's documents, namely the factsheet and key investor information document (KIID). It will tell you whether the replication of the ETF is physical or synthetic. You can find these documents on the fund provider's website.
Alternatively, you can find the information on justETF.com. For instance, the screenshots below show an ETF with respectively synthetic replication and physical replication.
Should you invest in physical or synthetic ETFs?
Synthetic ETFs have some advantages compared to physical ETFs in terms of cost and tracking error. But our belief is that the counterparty risk cannot be ignored. And when investing your life savings, this small risk can quickly outshine any small advantages synthetic ETFs offer. So we err on the side of caution and prefer to invest in physical ETFs when investing for the long term.
The right way with Curvo
Choosing an ETF, whether physical or synthetic, is not the end of the story. It's a small part of building a portfolio that will give you success over the long term. Defining the right portfolio is probably the most important and most difficult task for every investor. The composition of your portfolio is dependent on goals, your appetite for risk, your age and your income. We understand this difficulty, along with the many other subtleties investors have to deal with in order to be successful over the long term. For instance, a good understanding of the impact of taxes is important when managing your investments yourself. All this can be daunting, especially if you're just starting to invest.
Curvo was built to take away all the complexities of investing in index funds. No need to search through thousands of ETFs or scour wikis in order to understand how to select the right fund for you. Through Curvo:
- Invest in a portfolio tailored to you. Based on a questionnaire, the right mix of funds is selected for you that correspond to your goals and appetite for risk.
- Be safe. Your investments are secure and managed by NNEK, a Dutch investment firm licensed by the Dutch regulator (AFM).
- Set up a savings plan and put your savings on autopilot. Choose an amount and it will automatically be invested every single month.
- All your money is invested. In contrast with the majority of brokers, your investments work with fractional shares. This means that all your money is put to work. There will never be cash sitting on your account doing nothing.
- No entry or exit fees. There are no transaction fees, entry or withdrawal fees.
We showed the differences between a physical and synthetic ETF. Considering the risk involved with our life savings, we think it's best to stick with physical ETFs. They are also easier to understand and more transparent.
If you're still unsure with which ETF strategy to pursue, then take a closer look at Curvo. After all, we built Curvo to make index investing as easy as possible for everyone.
Questions you may have
How to choose the right ETF?
There are several things to look out for when choosing a good ETF:
- Underlying index
- Distribution of dividends
- Size of the fund
- Replication strategy
- Cost of the fund
- Transaction tax (for Belgian investors)
Learn more in our guide on index investing.