What are ETF Structures?
5 min

What are ETF Structures?

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When selecting an ETF, it helps to consider its structure. The build of the ETF determines how the target index is tracked, what assets you can hold, plus what visibility and risk to expect. Ultimately these impact total cost and projected returns.

What you will discover?

There are 2 types of ETFs: Physical ETFs and Synthetic ETFs. We will explore the differences and compare the advantages of both.

Let’s get physical

Most ETFs available today are physical. They are simple to understand and give you good visibility. A physical ETF tracks the target index by holding all, or some, of the underlying assets of the index. For example, a Hang Seng ETF will give you access to either all of the stocks traded on the Hang Seng, or at least a core basket of those stocks.

So, what’s a synthetic ETF?

A synthetic ETF does not invest in assets directly. For example, instead of owning barrels of crude oil, a synthetic ETF 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.

Who would want a synthetic ETF?

Synthetic ETFs are ideal if you want traditionally out of reach assets that are not covered by typical exchanges (think China A shares), or hard to access commodities (like crude oil).

Synthetic ETFs offer potentially higher return than say buying stocks or other tools that involve directly holding the asset. But synthetic ETFs often come with greater risk. Specifically counterparty risk, which is the risk that the counterparty fails to deliver the agreed level return specified in your synthetic ETF.

Comparing the good and the bad

Physical Replication

The manager of the funds physically buys and holds all or a representative subset of the shares in line with the index.

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Positives:

More transparent, easier to understand

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Negatives:

Can limit access to certain markets and exposures

Synthetic Replication

The manager uses derivatives – a contract between two parties related to a particular asset – rather than physically buying the assets.

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Positives:

Enables access to markets and exposures that physical replication may not

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Negatives:

Investors could be exposed to counterparty risk1

What should you go for?

Physical ETFs are more commonly available, meet most investment goals, and usually are lower risk. Synthetic ETFs can be described as more exotic. They may promise higher returns and come with greater risk. But you get access to assets normally out of reach, while also getting liquidity through the ability to trade at any time.

Sources

  1. Counterparty risk is the risk that a financial institution – the counterparty – may not be able to pay the index return.
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