how to tell if an etf is synthetic

How to Identify Synthetic ETFs

Synthetic ETFs, also known as "non-transparent" ETFs, are investment funds that use derivatives to track an underlying index or benchmark instead of holding the underlying assets directly. While synthetic ETFs offer certain advantages, such as lower costs and increased liquidity, they also come with unique risks. Here's how to determine if an ETF is synthetic:

1. Check the Prospectus

The prospectus, a legal document that outlines the details of the ETF, will explicitly state whether the ETF is synthetic or physically backed. Look for terms such as "synthetic replication" or "derivative-based" in the prospectus.

2. Examine the Holdings

Physical ETFs hold the underlying assets directly, while synthetic ETFs typically do not. If the ETF's holdings consist primarily of derivatives, it is likely synthetic.

3. Consider the Tracking Method

Synthetic ETFs use derivatives to mirror the performance of an underlying index. Physically backed ETFs, on the other hand, hold the actual assets that make up the index. Check the fund's website or prospectus for information on its tracking method.

4. Look for Credit Risk

Synthetic ETFs rely on counterparties, such as investment banks, to provide the derivatives they use for replication. If the counterparty defaults, the ETF may be exposed to credit risk. Examine the creditworthiness of the counterparties involved.

5. Factor in Tracking Error

Tracking error refers to the difference between the ETF's performance and that of its underlying index. Synthetic ETFs may experience higher tracking error due to the use of derivatives, which can introduce additional risks.

Additional Considerations:

In addition to these steps, consider the following factors:

• Risk tolerance: Synthetic ETFs may be suitable for investors with a higher risk tolerance.
• Investment horizon: Synthetic ETFs may be more appropriate for short-term investments.
• Investment goals: Consider whether a synthetic ETF aligns with your investment strategy.

By following these steps, you can identify synthetic ETFs and make informed decisions about whether they are right for your investment portfolio.