What's really in your ETF? Here’s how to find out

Most of the time when you buy an exchange traded fund (ETF), you're just looking to match the return from a particular part of the market. They are a type of tracker fund which, as their name suggests, trade on a stock exchange and seek to mirror the returns from a certain index.

Sounds simple and, in practice it usually is, but it’s still important to understand the product you are buying and what’s in it before you invest.

A traditional equity fund contains a portfolio of different companies, built by buying the relevant shares. An equity ETF tracks an index, which typically also contains a basket of stocks (although it can include other types of assets too). 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 a ‘swap’ agreement with a third party, usually an investment bank, that aims to delivers the return from the index minus fees.

While this methodology might sound a bit unusual it does not necessarily mean there is anything wrong with it.

What’s the point of a synthetic ETF?

Synthetic ETFs can generate returns that more closely match an index than a physical ETF. That sounds counter-intuitive, given the latter owns the underlying assets. It’s down to the complexities involved in 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 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 on their swap agreement with the bank. But, in many cases, this fee is smaller than the dividend tax would be, so it still provides a return closer to the index.

Some markets are tricky for overseas investors, including ETF providers, to access due to trading restrictions on foreign buying or selling or because the underlying assets can be tricky to buy and sell in a timely fashion. In these circumstances a synthetic product might be the only way of achieving exposure through an ETF.

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, the lines are blurred. A lot of products that include the word physical in their label will be a hybrid, with some of their assets tracked using swap agreements with a counterparty.

The amount can vary. Sometimes, it’s just a relatively small proportion. In other situations, it can be more than 50% of the fund. Alternatively, other ETFs own a sample of stocks from the index. This method is often used when an index has many individual constituents.

Different ways ETFs mirror an index

Source: AJ Bell

By using our investment search facility, you can get an idea of what kind of ETF you hold. Begin by searching and selecting your fund. Then, look under the section marked ‘Replication method’.

If it says ‘synthetic’, you know you are dealing with a synthetic ETF. If it says, ‘physical sample’, you are dealing with an ETF that invests some money directly in the assets but either engages in swaps on top or simply buys a proportion of the underlying assets in the relevant index.

You may also get a note that says, ‘physical full’. Even in these circumstances, the fund can still have some of its assets in swaps.