Basics

Index-based ETFs

The goal of an index ETF is to track the performance of a specific market benchmark as closely as possible.

Index-based ETFs are available in nearly every style and asset class, covering virtually every segment of the domestic and global equity and fixed income markets. They range from products that invest in the widest coverage of the markets, to those that invest in specific industries.

Some style ETFs cover the growth and value spectrum, and others track certain market-capitalization ranges. International ETFs cover the global markets and offer exposure to a single country or region of the world. Finally, fixed income ETFs cover a variety of duration, credit quality, and maturity ranges.

Other types of ETFs

A recent surge of interest in ETFs has led to significant product innovation. The latest global industry offerings include ETFs that go beyond a traditional index-based approach.

Actively managed ETFs

Rather than aiming to closely track a market index, the portfolio manager actively manages the assets within the ETF to achieve a particular investment objective. Actively managed ETFs represent a small but growing portion of the overall industry.

Commodity and currency ETFs

These ETFs invest in the commodities and currency markets either through physical assets or through the futures markets, providing investors with exposure to alternative investments such as agricultural products, precious metals, energy, and currencies.

Synthetic ETFs

ETFs can be classified as physical or synthetic depending on the nature of their underlying holdings.

Synthetic ETFs are distinct from the other ETF types described here. While most ETFs are classified as physical because they hold the actual securities that make up their underlying portfolios, synthetic ETFs rely on derivatives called swaps to execute their investment strategy.

Swaps are agreements between the ETF and a counterparty—usually a bank—to pay the ETF the return of its index. In essence, a synthetic ETF can track an index without actually owning any of its securities.

In many cases, especially when it comes to tracking less liquid, more exotic indexes, synthetic replication helps to reduce, but does not completely eliminate, tracking error. For instance, swap spreads (the cost of having investment banks provide an index's return) create tracking differences.

Though synthetic ETFs are available in many markets, they are most popular in Europe, where they were introduced in 2001.

How physical and synthetic ETFs work

Comparing physical and synthetic ETF structures

	Physical ETFs	Synthetic ETFs
UNDERLYING HOLDINGS	Index securities	Dividends or interest
TRANSPARENCY OF HOLDINGS	Yes	Historically limited; recently improving
COUNTERPARTY RISK	Limited	Yes
SOURCES OF COSTS	Management fee and transaction costs	Management fee and swap costs
SOURCES OF TRACKING ERROR	Level of portfolio optimisation; dividend treatment	Resetting of swap contract terms
FORM OF INCOME	Dividends or interest	None; NAV reflects total return of the index minus costs

_{Source: Vanguard}

Inverse and leveraged ETFs

Inverse and leveraged ETFs are types of synthetic ETFs. Inverse ETFs attempt to deliver the opposite, or inverse, returns of the benchmarks they track. An inverse ETF is expected to deliver a positive return on a day when its index goes down and a negative return when the index goes up.

Leveraged ETFs attempt to deliver multiples of the returns of the benchmarks they track. Such an ETF might be designed to return two or three times the value of the daily benchmark increase or, conversely, two or three times the benchmark's decline.

It's important to remember that most inverse and leveraged ETFs are designed to achieve their objectives daily. When held for more than a day, these ETFs can produce returns that differ from the inverse or leverage multiple. Inverse and leveraged ETFs are generally appropriate for an extremely narrow set of investment objectives—such as for short-term market timing or hedging purposes—and are not intended for long-term investment.

Counterparty risk

The chief risk of synthetic ETFs is counterparty risk. Essentially, synthetic ETF investors trust that the total-returns swap provider will meet its obligation to pay the agreed-upon index return. If that doesn't happen, investors risk incurring a loss. The key risk mitigator in the event of a counterparty default is collateral.