In Part 1 of our ‘Explaining ETFs’ series we looked at what ETF stands for and what they actually are, to recap ETFs are a type of investment that can be bought and sold, just like shares, through your stockbroker or an online trading account.
There are two types of ETFs – physical and synthetic. We explain these in detail below:
Physical ETFs
Many ETFs buy underlying investments like shares and other assets on the reference index the ETF aims to track.
When you invest in this kind of ETF you don’t actually own the underlying investments that the ETF buys – these are owned by the ETF. Instead, you own units or shares in the ETF.
The risks with this type of ETF lie in the performance of the underlying shares and assets.
Synthetic ETFs
A synthetic ETF is created to replicate the return of a selected index, but instead of holding underlying assets or shares they rely on synthetic holdings. These ETFs use derivatives – a security whose price is dependent upon or derived from one or more underlying assets, to track the index.
Synthetic ETFs traded on the ASX Quoted Assets market need to use the work ‘synthetic’ in their title, so you can clearly identify them. Synthetic ETFs can be bought and sold like shares, similarly to physical ETFs.
These ETFs can be matched more closely to changes in the value of their underlying investments with minimal errors before fees and taxes. While there are reduced tracking errors, investors do take on additional credit risks associated with the ETF derivative counterparty.
Synthetic ETFs can be riskier than Physical ETFs, this means it’s really important to fully explore all options before you step into this space.
Want to learn more about ETFs? Post a comment below, or get in touch with the Share Wealth team! We can help you take the first step in ETF investing…
