The recent surge of interest in ETFs has led to significant product innovation.
Global industry offerings include types of ETFs that go beyond active and traditional index-based products.
Balanced ETFs
Also known as asset allocation or "all-in-one" ETFs, these products aim to provide a complete portfolio in a single ETF through exposure to multiple asset classes (typically equity, fixed income and cash equivalents). Fund managers maintain a target asset allocation that keeps the portfolio risk at a predetermined level, freeing investors from the task of ongoing rebalancing. Some of these products gain asset class exposure by investing directly in securities, while others invest in other ETFs.
Commodity and currency ETFs
These ETFs invest in the commodities and currency markets either through physical assets or through the futures markets. They provide investors with exposure to alternative investments such as agricultural products, precious metals, energy and currencies.
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 leveraged 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.
Synthetic ETFs
ETFs can be classified as physical or synthetic depending on the nature of their underlying holdings.
Most ETFs—including those offered by Vanguard—are classified as physical because they hold the actual securities that make up their underlying portfolios. Synthetic ETFs rely on derivatives, mainly 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.
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 | Physical securities from underlying index | Derivatives/swaps and collateral basket (different from index in most cases) Collateral and/or swaps |
| Transparency | Yes | Limited (e.g. swap fees, collateral basket) |
| Counterparty risk | Limited (securities lending), always fully collateralized | Yes (derivatives/swaps), often collateralized |
| Sources of costs | Expense ratio, rebalancing costs | Expense ratio plus swap fee |
Source: Vanguard.
Counterparty risk
One of the main risks 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. Synthetic ETFs may also pose certain risks in the event of a higher volatility during significant market events.
Physical ETFs are also exposed to counterparty risk through any securities lending programmer. This activity, however, is always fully collateralized to protect investor assets.