Replication methodology
We examine the different approaches that ETFs can use to replicate a benchmark.
ETFs can be classified as physical or synthetic, depending on how they replicate the performance of the index they are designed to follow. As shown in this diagram, ETFs with physical replication hold the actual securities that make up their underlying portfolios. All Vanguard ETFs are physically replicated, as are about 80% of all ETFs issued. Synthetic ETFs, as shown here, rely on derivatives, mainly swaps, to execute their investment strategy. Swaps are agreements between the ETF and a counterparty - usually a bank - to pay the ETF the return of its index, plus or minus the spread, which is the swap price. The counterparty posts collateral in order to reduce the risk should it default on its obligation. As a result, a synthetic ETF can track an index without actually owning any of the securities.
Though synthetic ETFs are available in many markets, they are most popular in Europe, where they were introduced in 2001. That said, there is growing preference among investors for physical ETFs.
Let's look at a quick comparison between each type for underlying holdings, transparency, sources of cost and counterparty risk. Physical ETFs buy the actual securities from an underlying index, while synthetic ETFs rely on swap contracts with a counterparty to deliver the performance of that index, in return for a fee. With physical ETFs, there is complete transparency while with synthetic ETFs it's limited as it is not clear what collateral has been posted to cover the risk of counterparty default, or what the fee for the swap is.
The ongoing charges figure, or OCF, for a physical ETF includes the ETF provider's management fee, and other costs such as custody and administration fees. For a synthetic ETF, it includes the management fee, other costs such as custody and administration fees, and the cost of providing the swap. Physical ETFs can lend out the stocks in their portfolio in return for a fee.
The risks of doing this are limited as there are strict rules and any lending is always fully collateralised. But with synthetic ETFs, if the swap counterparty fails, the swap becomes worthless. Counterparty risk is one of the main risks of synthetic ETFs. The key risk mitigator in the event of a counterparty default is collateral. There are also regulations that limit how much of a fund can be exposed to a counterparty.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Important information
This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.
The information contained herein is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information does not constitute legal, tax, or investment advice. You must not, therefore, rely on it when making any investment decisions. The information contained herein is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.