Your ETF might not hold what you think it does – is that okay?

Exchange traded funds (ETFs) are a type of tracker fund and are meant to be a simple way to access a particular part of the market. You buy shares in the ETF and it mirrors the performance of a certain index. Look a bit closer and you’ll find some ETFs are not quite what you think are.

A traditional equity fund contains a portfolio of different companies, achieved through buying relevant shares. An equity ETF tracks an index, which itself contains a basket of stocks. In this sense, you might expect the ETF to also own the underlying shares. Some do, but others don’t. That’s why you need to look under the bonnet.

An ETF that holds the underlying assets in the index is called a physical ETF. There is also a synthetic ETF which doesn’t own the underlying assets, but instead has an agreement with a third party, usually an investment bank, that agrees to deliver the index’s return minus fees.

While this technique might seem unusual, it doesn’t mean that something is going wrong.

What’s the point of a synthetic ETF?

Synthetic ETFs can generate returns that more closely match an index than a physical ETF. You might think that sounds odd, given the latter actually own the underlying assets. It’s down to the complexities of precisely matching certain indices and issues around tax and regulations.

For example, let’s say you’d like to invest through a physical ETF that owns shares in US-listed companies. If that ETF is based in Ireland, it will have to pay a 15% withholding tax on any dividends (money companies pay out periodically to their shareholders) from the US investments in the portfolio. If the ETF is instead based in Luxembourg, a popular choice among ETF providers, it would have to pay a 30% tax on dividends.

If you were instead invested through a synthetic ETF, there would not be any withholding tax. Instead, synthetic ETFs may incur an extra fee from the trade with the bank. But in many cases, this fee is smaller than what the international tax would be, so still provides a return closer to the index.

How do I know what kind of ETF I hold?

So far, we’ve discussed physical and synthetic ETFs as two separate things. But in many cases, there’s some overlap between the two. A lot of products that are labelled as physical ETFs will still have some of their assets traded out on swap agreements with a counterparty. The amount can vary by a lot. Sometimes, it’s just a percent or two. In other situations, it can be over half of the fund.

By using our investment search, you can get an idea of what kind of ETF you hold. Begin by searching and selecting your fund. Then, look under replication method. If it says ‘synthetic’, you know you are dealing with a synthetic ETF. If it says ‘physical sample’. you are dealing with ETFs that invest some of their money directly in the assets, but still engage in swaps. You may also get a note that says ‘physical full’. Note that even in this case, the fund can have some of their assets in swaps.