Synthetic ETFs achieve their returns by entering into derivative transactions, such as swap agreements or futures contracts with counterparties rather than by buying the relevant assets themselves. We strongly recommend that investors read the relevant ETF prospectus to see whether the fund is backed by physical assets or is otherwise underwritten by financial derivatives. For funds backed with financial derivatives, investors should also ensure they understand the collateral arrangements in place to cover any potential default.
If an ETF provider chooses to generate additional returns by taking part in a stock lending programme, this can constitute a further risk, even with physically backed ETFs. Again investors should understand the collateral arrangements provided to cover any potential default.
A tracking error occurs when there is a difference between the performance of the ETF and that of the index or commodity it is designed to track.
There are a number of reasons why this could occur, including transaction and management costs.
Annual charges made by the ETF provider for managing the fund may cause it to underperform against its benchmark. Both physical and synthetic ETFs will also incur extra transaction charges such as re-balancing costs on a physical ETF or rollover fees on a futures contract. Both these factors could affect the performance of the ETF compared to the asset it is tracking.
An ETF can be priced in a currency different from that in which the assets are priced; for example, an ETF priced in sterling could be invested in and tracking the Dow Jones Industrial Average. In such a situation investors will face currency risk.
Leveraged and Short ETFs
Leveraged ETFs are complex instruments. They use futures or derivatives to achieve returns which exaggerate the movement of the underlying asset, e.g. rising (or falling) by 2% for every 1% rise (or fall) in the underlying asset.
Short funds use similar strategies but return a mirror opposite performance. For example, for every 1% fall in an asset, a leveraged short fund would deliver a 2% increase.
Losses can occur much more quickly with both types of funds than with more traditional investments but any losses would be limited to the amount invested.
Most ETFs are based offshore and their particular status will govern how gains or losses will be taxed. For example gains made when selling some funds will attract income tax within the UK. Investors should ascertain the type of tax treatment of any ETF they are considering investing in particularly with reference to their own individual circumstances.