ETFs: Physical or synthetic?

In a nutshell:

* ETFs can replicate a stock market index in several ways: physically or synthetically.

* Physical replication: this is a complete replication of the index. Physically replicating ETFs invest in exactly the same stocks that are included in the respective index. The values are also weighted exactly as they are in the index.

* Synthetic replication: In this form of index replication, investments are not made directly in the securities contained in the index. The index is replicated in synthetic ETFs using an exchange transaction - the total return swap.

* Advantages and disadvantages: While physically replicating ETFs are particularly transparent and therefore easy to track, synthetic ETFs have the advantage that they allow investors to participate in markets that are difficult to reach.

ETFs can replicate the index in different ways. There are two variants. Firstly, there are ETFs with direct replication, so-called physical replication. On the other hand, ETFs replicate stock market indices indirectly. This is called synthetic replication. Both types have advantages and disadvantages.

Physical ETFs $EUNL

Physical ETFs invest directly in the securities listed in the index that is being tracked.

If a stock is highly weighted in an index, it is also highly weighted in the ETF.

If share A has a 10% share in e.g. the DAX, the ETF must also weight share A with 10%, if it exactly replicates the DAX.

However, this "full replication" of an index is comparatively complex and cost-intensive. This is because the fund must invest in each individual stock and constantly adjust the weighting depending on the market situation. This becomes particularly difficult when it comes to broadly diversified indices that include many stocks.

The MSCI World contains more than 1,600 stocks, the ACWI about 3,000, and it would be very difficult and costly to include them all in the ETF. The index also contains illiquid stocks (*1), which are often impossible to buy in the necessary volume.

In such cases, sampling is often used.

Here, only the stocks that have the greatest impact are bought and those that are only slightly weighted are not included.

As a result, the ETF no longer tracks the original index one-to-one and thus the ETF performance may differ from the index performance. This is also referred to as tracking error or tracking difference.

Synthetic ETFs $X010

A synthetic replicating ETF does not invest directly in securities included in the index. Instead, it replicates the benchmark with a swap, via a so-called total return swap (TRS).

The ETF provider enters into a contract with a SWAP partner. In most cases, the parent bank. In the case of Xtrackers, Deutsche Bank.

The partner bank agrees to provide the ETF with the performance of the index, including all dividend payments. In return, the partner bank receives the return on a basket of securities that the ETF provider buys from investors' money and deposits as collateral.

These do not have to be the securities included in the index, but can be chosen at will.

For example, a collateral portfolio has a value of 100 million euros. If the underlying index increases by four percent, but the base portfolio only increases by two percent over the same period, the swap partner must pay the ETF the difference of two percentage points. In this case, that's two million euros. If, on the other hand, the underlying portfolio outperforms the index, the bank collects the excess return.

Synthetic replication is particularly useful for indexes that contain a large number of stocks or where the corresponding stocks are difficult to obtain. In the case of commodity indices, synthetic replicating ETFs are used almost exclusively, as it would be far too costly for the issuer to physically store all the commodities concerned.

However, a risk arises with synthetic replication in the possible bankruptcy of the partner bank if it can no longer meet its payment obligation and deliver the index return. The ETF provider must then fall back on the collateral portfolio and turn it into cash. However, if the value of this basket of shares is below the value of the index, investors incur a loss. According to UCITS guidelines (*2), this risk may not exceed 10%.

The counterparty or default risk can also be reduced by the swap partner itself providing collateral. In fully funded swaps, a special form of synthetic replication, the ETF invests exclusively in a swap and receives the index return in return for cash. There is no longer a carrier portfolio. The counterparty compiles the collateral basket and deposits it with a separate custodian bank.

Physical or Synthetic ?

There is no general answer to the question of which is better.

Those who decide to invest in ETFs should consider which model of index replication they are more comfortable with. The construction of physical ETFs is much easier to understand. Thus, those who act according to the principle "buy only what you understand" will, in case of doubt, opt for this variant.

However, this does not mean that synthetic ETFs are worse. However, those who buy them should be aware that their equity portfolio often has little to do with the actual index.

*1 Illiquid stocks are those that are only traded on the stock exchange to a very small extent. In most cases, these are very small companies that are not listed in any of the well-known indices (DAX, MDAX, etc.).

*2 UCITS Directive ("Undertakings for Collective Investment in Transferable Securities") $X010