The Difference Between Physical and Synthetically Backed ETFs

ETF providers are very transparent when it comes to replication and will explicitly disclose whether an ETF is physical or synthetic in the kit and prospectus

Jose Garcia Zarate 3 October, 2016 | 9:50AM
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This article is part of Morningstar's Guide to Passive Investing, helping investors make smart choices to meet their long-term investment goals.

 

 

Jose Garcia Zarate: Exchange-traded funds are index tracking vehicles. This means that they replicate the performance of a benchmark. European ETFs can employ physical or synthetic replication methodologies.

A physical ETF replicates the performance of the index by physically holding all or part of the index constituents. Meanwhile, a synthetic ETF replicates the performance of the index via swap agreements. This normally means that the synthetic ETFs hold a basket of securities which may not be related to the index they track. And what they do is exchange the performance of this basket for the performance of the index via a swap contract with a counterparty, which in most cases, is an investment bank.

Some investors may not care about the way that ETF goes about replicating the performance of the index. However, others may have a particular preference.

The good thing is that ETF providers are very transparent when it comes to replication and will explicitly disclose whether an ETF is physical or synthetic in the kit and prospectus.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe