Exchange-traded funds (ETFs) have grown in popularity over the past few years as they provide a low-cost way to invest in a wide range of asset classes. ETFs come in two different forms – synthetic and physical. While both types offer investors the same essential benefits, some critical differences can help investors make more informed decisions when choosing an ETF for their investment portfolio. This article will explore these differences so that you can choose the best ETF for your needs. Visit Saxo Capital Markets PTE to learn more.
Price tracking methodology
The first distinction between synthetic and physical ETFs is how they track the prices of the underlying assets they are invested in. Physical ETFs purchase actual units of the underlying asset, such as stocks or bonds, and the value of these holdings dictates the fund’s performance. In contrast, synthetic ETFs use derivative contracts to track the prices of the underlying assets.
Asset class exposure
Physical ETFs provide investors with direct exposure to their chosen asset classes and will not deviate from those holdings unless they are rebalanced periodically. Synthetic ETFs, however, can gain exposure to multiple asset classes at once by using derivatives such as options, futures and swaps. This flexibility allows investors to access different markets more efficiently but also carries additional risks due to its complexity.
Tax implications
Physical ETFs tend to have lower taxes than synthetic ETFs because of their direct ownership of the underlying assets. This is due to synthetic ETFs typically having higher turnover rates and, thus, more capital gains taxes applied to them. Depending on your investment strategy, this could make a difference when choosing between the two types of ETFs.
Cost structure
The cost structure between physical and synthetic ETFs also differs significantly. Physical ETFs usually incur brokerage fees when buying or selling units, whereas synthetic funds are generally subject to management fees which vary depending on the fund’s complexity and size. While these fees can be significant for some ETFs, there may also be other hidden costs involved.
Market liquidity
Market liquidity is another factor to consider when comparing synthetic and physical ETFs. Physical ETFs tend to have higher market liquidity as they can be bought and sold on the open market, while synthetic ETFs depend more on the counterparty’s willingness to buy or sell. This could lead to delays in executing trades and thus affect your investment returns.
Trading restrictions
Synthetic ETFs also tend to have more restrictions when trading them than physical funds, such as minimum and maximum trade sizes, order types, etc. On the other hand, physical ETFs usually have fewer restrictions and provide investors with greater flexibility in their trades.
Transparency
The level of transparency between synthetic and physical ETFs is also different. Physical ETFs usually disclose all of the holdings they have in their portfolio. In contrast, synthetic funds may not reveal how much of each asset class they are invested in or what derivative contracts they use to gain exposure. This can make it difficult to assess the risk associated with a synthetic ETF before investing.
Tracking error
Tracking error is another key difference between synthetic and physical ETFs that should be considered when selecting an appropriate fund for your portfolio. Tracking error occurs when the fund’s performance does not match up precisely with the underlying benchmark. This can lead to either higher or lower returns depending on the situation. Physical ETFs usually have less tracking error as they are directly invested in the underlying assets, while synthetic ETFs may suffer more due to their use of derivatives.
Counterparty risk
Counterparty risk is another aspect that should be considered when comparing synthetic and physical ETFs. Synthetic funds have more counterparty risk as they depend on the other party’s willingness to buy or sell their derivative contracts, whereas physical ETFs do not have this additional risk.
Diversification benefits
Lastly, it is essential to consider the diversification benefits offered by both synthetic and physical ETFs. As synthetic ETFs can offer exposure to a broader range of asset classes, they may provide more significant diversification potential than physical funds. However, this should be weighed against the risk associated with these types of products before investing.
All in all
With all the differences between synthetic and physical ETFs outlined above, it is essential to thoroughly research and understand what type of fund best suits your investment objectives. Both have advantages and disadvantages, but ultimately, it is up to the investor to decide which is most appropriate for their portfolio. By considering the various factors outlined, investors should be able to select the best ETFs for their needs.
