ETFs, or exchange-traded funds, have two different types: physical and synthetic.
- Physical: Physical ETFs invest directly in the underlying asset or assets which they track. For example, an FTSE 100 tracker invests in the shares of the companies that make up the FTSE 100 Index; a gold ETF invests in physical gold bullion which is stored in a vault. Note that although the underlying assets are physical, you don’t buy the assets yourself when you invest in an ETF, you are just buying a stake in the ETF,
- Synthetic: Synthetic ETFs do not invest in underlying assets, but in a type of derivative called ‘swaps’ which are sold by investment banks. Swaps promise to pay the same returns as the index or investment they track without the ETF owning the underlying asset. The advantage is that they allow you to invest in markets that otherwise might be hard to access, such as stock markets that have restrictions on foreign investment.
Physical ETFs trade like shares so you can add them to your portfolio with no more risk than buying shares directly. Synthetic ETFs are risker because if the investment bank that sold the swap to the ETF can’t meet its obligations, you could lose out – this is known as ‘counterparty risk’. Because of this, physical ETFs are more suitable for individual investors; they are much easier to understand and less vulnerable to risk.