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EXCHANGE-TRADED FUNDS | MODULE 4

ETF STRUCTURES

Continue the ETFs course with module 4 to explore the advantages and drawbacks of the two types of ETFs – “physical” and “synthetic.”

WHY ARE ETF STRUCTURES IMPORTANT?
When selecting an ETF, it helps to consider its structure. The build of the ETF determines how the target index is tracked and what assets the index can hold. This impacts total cost, projected returns and anticipated risk.
Why are ETF structures important?

WHAT IS A PHYSICAL ETF?

What is a physical ETF?

Most ETFs available today are physical. A physical ETF tracks the target index by holding all, or some, of the underlying assets of the index. 

For example, an ETF that tracks the S&P 500 Index will consist of either all 500 companies in the S&P 500 Index, or a representative sample of that basket of stocks.

WHAT IS A SYNTHETIC ETF?

What is a synthetic ETF?

A synthetic ETF does not invest in assets directly, but is ideal for exposure to hard-to-access assets, like commodities such as crude oil. 

For example, instead of owning barrels of crude oil, a synthetic ETF that is tracking oil will hold a series of oil futures contracts. These agreements are set up with a third party, often an investment bank, who promises to pay back an agreed level of return when oil reaches a certain price. 

Synthetic ETFs can often offer higher potential returns than buying stocks or other vehicles that involve directly holding the asset, but they also often come with greater risk.

COMPARING THE ADVANTAGES AND DRAWBACKS

Physical ETFs
Advantage
Advantage
Transparent and easy to understand.
Drawback
Drawback
Can limit access to certain markets
and exposures.
Synthetic ETFs
Advantage
Advantage
Provides access to markets and exposures that physical replication
may not.
Drawback
Drawback
Often have great risk, including potential exposure to
counterparty risk.*

* Counterparty risk happens when the counterparty fails to deliver the agreed level of return specified in the synthetic ETF.

THINK DIFFERENTLY

When considering how to pick between the two structures, consider the clients’ investment goals. Physical ETFs are more widely available and usually have lower risk. Synthetic ETFs can provide greater access to different assets with potentially higher returns, but often with more associated risk.

 

This concludes the fourth module of the ETF course. Read the next module, which explores how to implement ETFs into a portfolio, to continue the course.

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