ETFs: Are physically replicated or synthetic products the way to go?

ETFs range from the straightforward tracking of developed markets indices such as the FTSE 100 or the S&P 500 to the more illiquid and difficult-to-trade shares like Indian or Pakistani company shares. There are also alternatives such as baskets of water company shares or cyber security and robotic company shares.

A physical replication ETF is essentially a basket of shares that holds all or most of the shares as per the index the ETF is tracking. This type of ETF is generally thought of as more transparent as the investor knows what is held in the ETF basket.

However, the negatives of this type of structure can limit access to certain markets like Pakistani or Indian shares or an index which tracks thousands of fixed income bonds, which may be illiquid or too expensive to trade like a global aggregate bond ETF.

Likewise, with a physically replicated ETF it would be very expensive to track every single emerging market company that is listed in an index because of the illiquidity of some of the shares in that index and the cost of trading.

A synthetic or swap-backed ETF is a structure which enables the ETF manager to trade with a third party using a derivatives contract to obtain the return of the index it is tracking. This type of ETF generally holds a basket of shares or bonds as collateral (not necessarily the same as the index shares) and will “swap” the return of the collateral basket for the return of the index with the third party.

However, these are not as transparent as the physical structure and have further counterparty risks if the third party supplying the swap cannot deliver the return of the index, although the investor is still entitled to the return of the collateral. This is unlikely, but still a risk.

Another negative for synthetic-type ETFs is that many have an extra charge for the cost of providing the swap – in some cases this can be considerable. A synthetic Indian equity ETF can add an extra 1 per cent of charges onto the cost of owning this vehicle and a Pakistani equity ETF can add at least an extra 5 per cent of charges or more for the cost of the swap and taxes – this is in just one year alone.

While an investor could access Pakistani equities through an ETF, the returns could be a long way behind its benchmark returns. In 2016 a Pakistani ETF returned around 60 per cent in sterling terms but this was approximately 10 per cent behind the benchmark due to taxes and the cost of the swap.

On a positive side, the Amundi MSCI Emerging Markets ETF, which is a synthetic ETF, performed very well over the past year compared with its underlying benchmark, while the iShares MSCI Emerging Markets ETFs have underperformed the benchmark by a little more than the TER/OCF of the ETF.

The  iShares MSCI Emerging Markets ETF is a physical replicating ETF (although it doesn’t hold every share in the index because it would be too costly to do so) which shows that it can sometimes be more costly trying to physically replicate the index, depending on what shares are
being bought.

However, many UK investors have favoured the physical replication products and, over the past year or so, ETF providers have taken this on board. Amundi, Lyxor and db x-trackers were some of the original ETF providers who chose to launch synthetic ETFs only. But only over the past year have they been switching some of their products into physical replication ETFs while new launches have tended to be physical replication as well. This move has attracted more investors to their products.

At Charles Stanley we continue to favour the physically-replicated ETFs but do use some synthetic ETFs if there are no alternatives, or if these type of ETFs offer better value in terms of costs and performance returns.

Lynn Hutchinson is assistant director at Charles Stanley