Synthetic ETF vs. Physical ETF: Avoid mistakes and protect your money

Synthetic ETF vs. Physical ETF: Avoid mistakes and protect your money

"Too big to fail" they boasted.

In 2008 their claims were proved false.

The financial crisis marched in and left a broken banking world that cried "save us". The US government lent funds to the three largest US banks. Only the fourth stared into an empty purse.

Lehman Brothers went bankrupt.

After a 14-year process, this cost over $424 million, with $75 billion damage. Smaller and larger investors alike have lost money.

Financial crises are as much a part of our world as coffee is with cake. You go bankrupt with the banks if you ignore the replication method.

You can now find out what this method is and which one you choose for long-term safe investments.

Mann, der sich die Haare rauft.

What does replication method mean?

A replication method is a way in which ETFs precisely replicate the index on which they are based. Every ETF aims to exactly replicate its underlying index. Thus, the replication method is an important detail when choosing an ETF.

For example: An MSCI World ETF reconstructs the world stock index.

This is important for you.

Each ETF replicates its index differently.

Three replication methods have become established.

  • Physically complete replication

  • Physically optimized sampling

  • Synthetic (unfunded swap)

Which replication method is used determines which subtopics your money is invested in. Unlike the fund manager, a computer does this for you in the ETF world.

Physical ETF: Full replication

Vollständige Replikation

The ETF is composed in the same way as the index. If Deutsche Telekom is represented in the DAX index with 6.3%, Mercedes-Benz with 4.5%, and BMW with 3.5%, these companies are represented in the ETF with the same percentage shares.

The ETF computer uses your money to buy physical stocks of companies according to the percentages found in the index.

What does that mean specifically?

Your 2000 € that you invest will be invested proportionately: 126 € in Deutsche Telekom, 90 € in Mercedes-Benz and 70 € in BMW.

You invest in indices with only a few companies like the DAX or the Dow Jones Industrial Average, then choose an ETF with the full replication method.

Why?

Because less is adjusted in smaller indices:

  • One company out, a new one in

  • Percent weight changes

  • Shares are repurchased

These adjustments cause transaction costs. The ETF computer needs to fill up. During this time, there are short-term deviations from the index (tracking difference).

The higher the tracking difference, the worse the ETF performance. The tracking difference (tracking error) is lowest for indices with few companies.

If an index contains more than 1000 companies or has a very small ETF volume, the cost of fully replicating the index is too high and optimized sampling is preferable.

I'll tell you what that is in the next section.

The table first shows you how many companies there are in each index and which replication method I recommend.

Index

Number of companies

Replication method

DOW Jones Ind. Average

30

complete

Euro Stoxx

50

complete

Nasdaq Composite

100

complete

S&P 500

500

complete

MSCI World

more than 1600

optimized

MSCI World Emerging Markets

more than 1300

optimized

Physical ETF: Optimized sampling (optimized replication)

With physically optimized sampling, the ETF computer buys stocks. Just like full replication.

The difference?

It only invests in stocks that have the greatest impact on overall performance. This optimized selection ignores illiquid companies and stocks with small weights (less than 0.01%, for example).

Your ETF computer will also be equipped with computer models to replicate the ETF performance 1:1.

Optimiertes Sampling

The advantage over full replication is that fewer different stocks are bought and thus the transaction costs are lower. This is usually reflected in a lower total expense ratio (TER) per year.

The disadvantage is that the index development is not 100% accurate and there can be an increased tracking difference.

And what about diversification?

Good question.

My answer is, don't worry about it.

The diversification remains mostly because only the very low weighted stocks are left out. This results in sufficient capital diversification.

Optimized sampling is suitable for the MSCI World or the MSCI World Emerging Markets.

Synthetic ETF: Unfunded Swap

With the synthetic replication method, the index is not reconstructed, only the index return is replicated. This involves entering into a contract with a partner, often the parent company of the ETF provider.

In the third option, the ETF provider not only invests in shares, but also in synthetic products such as options or derivatives. This process is not transparent for you. It is no longer the goal to replicate the index, but to invest with your money and achieve a higher return than the index.

It's great, isn't it?

Yes, it would be.

If you got the return.

But the return goes to the parent company (swap partner) of the ETF provider. In return, the swap partner protects the ETF provider in bad times.

What does that mean?

If a lower return is earned, the parent company pays the return that the index has earned. Until it goes bankrupt (counterparty risk).

How exactly does this work?

Here's an example.

You buy shares of a synthetic ETF managed by ETF provider Db Xtrackers. This invests your money in a carrier portfolio. This may include securities that are not part of the index. The carrier portfolio makes up 12%, which goes to the swap partner, Deutsche Bank. The index has made 10%. This index return of 10% is paid to the ETF provider.

Index return is paid even if the carrier portfolio returns less than the index. The ETF provider is hedged, but the parent company is struggling. Because the swap partner bears the risk, they determine in which securities your money is invested.

Synthetische ETFs

That calls for a business model for the parent company on the backs of ETF investors. In this case, you are taking the brunt of the bank’s financial hits.

It is not for nothing that the EU has defined a law that reduces the counterparty risk, i.e. bankruptcy of one of the two parties. This does not rule it out.

In conclusion, stay away from synthetic unfunded swap ETFs.

Everyone says that swaps are perfect for investing in illiquid emerging markets, niche markets and sectors.

Rather, the question is.

Do you really want to invest in the index of Vietnam?

No.

Illiquid remains illiquid.

They are susceptible to disproportionate price fluctuations. The risk is in your face.

This is fine for you.

Ok.

Then invest and pay attention to the following:

  • Invest with a smaller portion of your portfolio

  • Check regularly

  • Have an exit strategy ready

What about hyped sectors like biotech?

Yes.

Invest.

But be sure to compare with other ETFs and pay attention to the replication method (replication).

For example, JustETF has two ETFs on the North American biotechnology sector with almost identical master data.

With the little difference in the replication method. Choose the physical replication method here as well.

Replication method example

Conclusion

Never invest in a Synthetic ETF for the long term.

The risk is too high, and there are alternatives with physical ETFs.

When choosing an ETF, pay attention to this small but subtle difference and your money will be better invested in the long term.

If you are interested in further reducing the risk of your ETF investment, I recommend my S&P 500 ETF strategy. There, by checking the stock indices weekly, I achieve a much smaller drop in capital than with a conventional buy and hold investment.

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