Physical or synthetic ETF?
ETFs are roughly divided into two kinds: synthetic and physical. Simply put, physical ETFs are those where the owner of the ETF owns all or a majority sample of the underlying securities through the ETF. So if you have an ETF on the S&P 500 then you are actually the owner of your representative number of shares in each of those 500 stocks. When an index-tracking ETF does not own all the constituents of the index in exactly the same proportions as the index all the time, this introduces a tracking error. This tracking error is entirely normal and unless a provider consistently underperforms an index as a result of it (suggesting other issues) it’s not something you should expect to make or lose a lot of money from at least among the major ETFs.
Synthetic ETFs are a little different. Here the provider, such as Deutsche Bank (their brand is DB Trackers) will aim to replicate the performance of the index, but you as an investor do not own the underlying securities. This creates a credit exposure to the provider (here Deutsche Bank) in case it goes bust. The synthetic ETF providers argue that they are better able to replicate the performance of the index they seek to produce by using certain derivative products. Furthermore they argue that there is a great deal of collateral backing the ETF. So if you have $100 in a synthetic ETF there may be $120 of collateral of other securities backing that ETF. The providers also argue that this renders the risk of the synthetic ETF minimal and well worth taking to get more accurate tracking of an index, and perhaps slightly better returns from the financial manoeuvring the synthetic provider can undertake.
I was recently helping an African development institution select some ETFs for their investment portfolio. As I tried to explain the difference between physical and synthetic ETFs, one of the directors cut me off.
‘So you are saying that in one of the cases we own what we think we own, and in the other we may own a bunch of other stuff if Deutsche Bank goes bust. Try to explain to my minister that we invested in a synthetic or in any way a derivative product with taxpayers’ money. He would eat me alive.’
So we went with physical ETFs.
I see why many people choose physical ETFs. The synthetic somehow doesn’t feel right to a lot of people, and explaining it in simple terms often doesn’t make them feel much better. Personally I have no problem with the synthetic products and accept the minor extra risk that comes with them. But while physical ETFs increasingly dominate the market, from my perspective the decision between physical and synthetic ETFs is less important than selecting the right ETF on the basis of tax considerations, liquidity or cost.