Exchange-traded funds (ETFs) have become a popular investment vehicle for Singapore’s retail and institutional investors. These funds provide diversification, flexibility, low costs, and tax efficiency to investors seeking exposure to global markets. ETFs can be categorised into two main types: synthetic and physical. Synthetic ETFs use derivatives such as swaps or options to replicate the performance of an underlying index.
In contrast, physical ETFs hold a basket of securities that mimic the index they track. Both types of ETFs have unique characteristics and advantages, which investors should consider before investing in them.
Structure
The most significant difference between synthetic and physical ETFs lies in their structure. Synthetic ETFs are structured as derivative products, whereas physical ETFs are structured as investment trusts or funds. This difference affects various aspects of the ETF, including transparency, liquidity, counterparty risk, and tracking error.
Synthetic ETFs use derivatives to achieve their investment objective, making them more complex than physical ETFs. Derivatives are financial instruments whose value is derived from the performance of an underlying asset, such as a stock index or commodity. Using derivatives allows synthetic ETFs to track indices they cannot hold physically due to regulatory restrictions or high costs. However, this structure introduces counterparty risk, where the derivative provider may fail to honour its obligations.
On the other hand, physical ETFs hold a basket of securities, making them more straightforward and transparent than synthetic ETFs. The underlying assets are held in a custody accounta third-party trustee or custodian, reducing counterparty risk. Moreover, physical ETFs are more liquid than synthetic ETFs, as investors can buy and sell the underlying securities that comprise the fund. This liquidity also helps reduce tracking error, the difference between the ETF’s performance and index.
The best ETF to buy now would depend on an investor’s investment objectives, risk appetite, and portfolio size. Synthetic ETFs may be the better option for investors looking for low-cost exposure to a broad index. On the other hand, those seeking more straightforward structures and physical holdings may prefer physical ETFs.
Cost
When choosing between synthetic and physical ETFs, investors consider cost essential. Synthetic ETFs typically have lower fees than physical ETFs due to their structure. Physical ETFs must bear additional costs, such as transaction, custody, and management fees, that synthetic ETFs do not incur. However, it is essential to note that synthetic ETFs may also charge swap or derivative-related fees.
Physical ETFs are usually less expensive for investors with large portfolios due to bulk discounts offeredthe underlying securities’ custodians. On the other hand, synthetic ETFs may be more cost-effective for smaller portfolios as they do not have minimum investment requirements.
Regarding tax efficiency, trading ETFs of either variety is generally similar in Singapore, where there is no capital gains tax or dividend withholding tax. However, synthetic ETFs may be more tax-efficient for investors who hold them in taxable accounts, as they do not distribute dividends. In contrast, physical ETFs’ underlying securities may have dividend distributions subject to tax.
Tracking error
Tracking error differs between an ETF’s performance and the index it tracks. While synthetic and physical ETFs aim to replicate an index’s performance, several factors may cause tracking errors. The primary factor for synthetic ETFs is counterparty risk, where the derivative provider fails to replicate the index’s return accurately.
For physical ETFs, tracking errors can occur for various reasons, such as transaction costs, fees, and taxes. These costs reduce the ETF’s return compared to the index it tracks. However, physical ETFs’ tracking errors are generally lower than synthetic ETFs as they do not rely on derivatives.
Market conditions can also affect tracking errors, especially in volatile markets. During periods of high volatility, tracking errors may be more significant for both types of ETFs due to increased transaction and hedging costs. However, physical ETFs may be more affectedtracking errors in extreme market conditions due to their underlying securities’ liquidity.
Index replication
Synthetic and physical ETFs use different methods to replicate the performance of an index. Synthetic ETFs use derivatives such as swaps or options to achieve this objective, while physical ETFs hold the underlying securities. This difference can affect the ETF’s performance and risks.
Synthetic ETFs’ use of derivatives allows them to replicate indices that are difficult or expensive to hold physically. However, this also introduces counterparty risk, as mentioned earlier. The ETF may not accurately track the index’s return if the derivative provider fails. Synthetic ETFs may also be subject to changes in the terms of their derivatives, impacting the fund’s performance.
Physical ETFs’ use of underlying securities allows them to track the index they follow, reducing tracking errors accurately. However, it also means that these funds are subject to market risks and volatility. During periods of high market volatility, physical ETFs may experience more significant fluctuations in their value compared to synthetic ETFs, which use derivatives to hedge against market risks.