Invest in New Markets with Synthetic ETFs

Another day, another new batch of ETFs on BUX Zero! We just added 32 new ETFs to the app to bring you even more investment opportunities. 

You might notice something different about our latest offering. Many of them are ‘synthetic’ ETFs. What does that mean? And what are the benefits (and risks) involved? Let’s take a look.

Synthetic ETFs: the quick version

  • Unlike ‘physical’ ETFs, synthetic ETFs do not hold the exact shares and assets of the underlying index. Instead, they use agreements with a bank, known as ‘swaps,’ to track a particular index.
  • In theory, synthetic ETFs have lower costs. They may also track the index better and help you invest in more exotic markets.
  • However, it does introduce some counterparty risk.

If that sounds confusing, let’s go back to the basics to explain how it all works.

First, what’s an ETF?

An ETF is simply a bundle of investments. Instead of buying one stock at a time, ETFs allow you to invest in dozens, hundreds or even thousands of stocks with just one product. It usually tracks a broad index, such as the S&P 500 or the German DAX. (If you’re new to ETFs, check out our ETF Knowledge Centre).

However, there are two different ways an ETF can track that index: ‘physical’ or ‘synthetic.’

Physical ETFs

A physical ETF replicates the index exactly. In other words, the fund physically buys and holds every stock that makes up the index, with the exact same weighting.

So, to replicate the S&P 500, the fund will buy shares from all 500 companies. And they’ll rebalance it regularly to make sure it always matches the performance of the index.

Synthetic ETFs

Synthetic ETFs are different. They do not hold the physical shares. Instead, they use derivatives such as futures contracts and, more commonly, swaps.

Wait, what’s a swap? This is basically just a contract or agreement with another bank to pay the exact return of the index. Again, that might sound a little complex so let’s use an example.

Bank A wants to issue an ETF that tracks the S&P 500. Bank A gives the investment money to Bank B (known as collateral), and Bank B promises to give it back with the exact return-on-investment of the S&P 500 index.

This is a simplified explanation, but it’s roughly how it works.

What are the benefits of synthetic ETFs?

  1. Cost – Synthetic ETFs are often cheaper to operate because they don’t have to constantly buy and sell assets. Rebalancing a physical ETF requires lots of transaction costs and management fees.
  2. Tracking accuracy – Synthetic ETFs often track the underlying index more accurately. Again, this is because they don’t have to keep rebalancing.
  3. Access to more exotic markets – It can be expensive to create a physical ETF that tracks niche industries and remote markets because they are less liquid. Synthetic ETFs can do it at lower costs.

What are the risks?

The European Central Bank and the US Federal Reserve have both noted that synthetic ETFs do come with a little extra risk. 

Specifically, you have to trust that the two banks can hold up their agreement to repay the swaps. This is called counterparty risk. In other words, there’s a risk that the other bank goes bankrupt and cannot pay.

There’s also a small risk of transparency. With physical ETFs, you know exactly what’s in the fund. With synthetic ETFs you don’t always know the exact swaps and derivatives included.

Synthetic ETFs on BUX Zero

The good thing about synthetic ETFs is getting the opportunity to invest in emerging markets and niche industries. Below are some ETFs on BUX Zero that allow you to do just that!

Lyxor India ETF

This ETF captures the performance of the broad Indian stock market. It tracks the MSCI India Index, which is a basket of 107 major companies in India, capturing approximately 85% of all market capitalization in the country. Companies include Reliance Industries, Infosys and Axis Bank, among others.

Xtrackers FTSE Vietnam UCITS ETF

Get exposure to the broad Vietnamese stock market. This ETF tracks the FTSE Vietnam index, which is a collection of 30 major companies listed on the Ho Chi Minh City Stock Exchange. Stocks include Vincom, Saigon Securities, Hoa Phat and Vinamilk.

Lyxor Hong Kong UCITS ETF

This ETF captures the performance of the Hong Kong stock market. It tracks the Hang Seng Index, which includes 64 of the largest and most liquid companies in the region. Stocks include HSBC Holdings, Tencent Holdings, Alibaba Group Holdings, Ping An Insurance Group and more.

Invesco Nasdaq Biotech ETF

This ETF is a basket of leading biotech and pharmaceutical companies. It tracks the NASDAQ Biotechnology Index, which includes 373 biotech stocks such as Amgen, Gilead, Moderna, Illumina and Biogen, among others.

Lyxor Stoxx Europe 600 Food & Beverage ETF

Get exposure to all of Europe’s largest food and drinks companies. This ETF tracks the STOXX Europe 600 Food & Beverage Index, which is a basket of 26 companies that make most of their revenue from the food and beverage industry. Stocks include Nestle, Heineken, Danone, Carlsberg and Pernod-Ricard.

All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.