October 3, 2022
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Business

The distinction between physical and synthetic ETFs

An Exchange-Traded Fund, also known as an ETF, is a type of investment that allows investors to trade and invest in a portfolio without directly buying the underlying securities. ETFs in the Netherlands are traded on stock exchanges and can be bought and sold throughout the day like any other stock.

The benefits of trading ETFs

Over the years, ETFs have become widely popular and sought after, and they are currently actively traded by many. Below are a few benefits of trading ETF trading which could help explain their popularity.

Access to a wide range of asset classes

ETFs expose investors to various asset classes, including stocks, bonds, commodities, real estate, and forex in one go, with a basket of investments. Usually, assets included in ETFs are also pre-picked out by brokers or exchanges, which makes it even more convenient for traders. This diversification can help investors reduce risk and improve returns, while making it easier for them to place trades in the first place.

Lower costs

ETFs tend to have lower fees than traditional mutual funds because they are not actively managed. This means that traders can make the most out of each trade and maximise any profits they make on their trading journey.

Higher liquidity

ETFs are highly liquid as they have become widespread and popular. As such, they can be bought and sold quickly because they are traded on stock exchanges and have high daily trading volumes, with lots of buyers and sellers and good levels of supply and demand.

What is a synthetic ETF?

You may also have heard of synthetic ETFs, which is a type of ETFs.

A synthetic ETF is an exchange-traded fund that uses derivatives to provide exposure to the underlying asset. The use of derivatives allows the ETF to track the performance of the asset without owning it. Synthetic ETFs are also sometimes referred to as “swap-based” or “exchange-traded notes (ETN)”.

The benefits of synthetic ETFs include:

Lower costs: Synthetic ETFs tend to have lower fees than traditional mutual funds because they do not require the same level of overhead.

Higher liquidity: Synthetic ETFs are highly liquid, meaning they can be bought and sold quickly because they are traded on stock exchanges and have high daily trading volumes.

What are the risks of synthetic ETFs?

Synthetic ETFs are complex financial instruments and come with several risks. These risks include:

Counterparty risk: The use of derivatives exposes investors to counterparty risk, the risk that the other party to the contract will not fulfil their obligations leading to losses for the investor.

Tracking error risk: Synthetic ETFs may not track the performance of the underlying asset perfectly. This tracking error risk is because derivatives are not always a perfect substitute for the underlying asset.

Credit risk: Investors in synthetic ETFs are also exposed to credit risk, which is the risk that the issuer of the ETF will not be able to meet its financial obligations, leading to losses for the investor.

What is a physical ETF?

A physical ETF is another type of Exchange-Traded Fund. Physical ETFs track a target index by holding some or all the assets of the index. For example, an ETF that tracks the S&P 500 index, one of the largest and most popular indices in the US that contains the 500 largest companies by market capitalisation, can track the performance of all 500 companies or a small pool of companies from the list of 500.

The benefits of physical ETFs include

Transparency: Physical ETFs offer greater transparency than synthetic ETFs because investors can see exactly what assets the ETF holds.

Lower tracking error risk: Physical ETFs tend to have lower tracking error risk than synthetic ETFs because they own the underlying asset and are not subject to the same price movement.

What are the risks of physical ETFs?

Physical ETFs are complex financial instruments and come with several risks. These risks include:

Counterparty risk: Using derivatives exposes investors to counterparty risk, the risk that the other party to the contract will not fulfil their obligations leading to losses for the investor.

The key advantages of physical ETFs over synthetic ETFs

There are a few key advantages of physical ETFs over synthetic ETFs.

First, physical ETFs are generally more transparent since you can see which securities are held in the fund’s portfolio. On the other hand, synthetic ETFs often use complex derivatives strategies that can be difficult for the average investor to understand.

Second, physical ETFs tend to be more tax-efficient than synthetic ETFs because capital gains taxes are only incurred when securities are sold. Most physical ETFs have turnover rates much lower than their synthetic counterparts.

Conclusion

While physical and synthetic ETFs have advantages, physical ETFs tend to be the better choice for long-term investors. They are more transparent, tax-efficient, and resilient in volatile markets. Plus, they offer proper diversification that can help to protect your portfolio from the risk of any one security going bad. For more info on how you can get started trading ETFs, you can visit a the website of a reputable and reliable broker in the Netherlands, such as Saxo Bank.