Not all exchange-traded funds are as toxic as some claim, writes John Kavanagh. The fund manager BetaShares Capital, a provider of exchange-traded funds (ETFs), sent an announcement to the Australian Securities Exchange earlier this month, informing the market that it had modified the investment strategy of two of its ETFs.The two funds in question had used derivatives (equity swaps) in their structures and were classified by the ASX as "synthetic" ETFs. Under the terms of the product disclosure statements issued on October 11, both funds (BetaShares S&P/ASX 200 Financial Sector ETF and BetaShares S&P/ASX 200 Resources Sector ETF) would in future use investment strategies based on conventional, physical stock index replication.Synthetic ETFs have been the cause of a storm of bad publicity in recent weeks, with some commentators arguing they are the latest toxic investment to plague world markets.The Australian Financial Review reproduced an article from The New York Times on October 12, headed: "ETFs are 'new weapons of mass destruction"'.Sounds bad but what investors need to know is that there are ETFs and then there are ETFs. Like any investment class, the label covers a wide range of products with varying degrees of complexity and risk."Generally, what we are talking about is a registered managed investment scheme, like a managed fund, that is traded on a market, such as the ASX," a partner at Mallesons Stephen Jaques, Susan Hilliard, says.Tracker funds"In most cases the funds are tracker vehicles they replicate an index such as the S&P/ASX 200 and are passively managed," Hilliard says. "Their goal is to track the performance of the index as closely as possible."Replication is done physically, which involves buying a basket of stocks that will provide a return that is close to the index return. Variance from the index return is called tracking error and ETF managers try to keep it to a minimum.ETFs of this type are attractive for several reasons: they are cheap, the assets are liquid and the investment strategy is simple and transparent.Among the 57 ETFs listed on the ASX, management expense ratios are as low as 0.15 per cent of funds invested. ETFs that invest in overseas markets cost more but even the most expensive of those, at 0.82 per cent of funds invested, is relatively cheap compared with other managed funds.Liquidity comes through ASX listing. Trading volumes for the bigger ETFs run into millions of shares a month.ETF providers publish details of their holdings. This transparency contrasts with the practices of many managers of unlisted managed funds, which provide little or no detail of their holdings.The ASX listed its first ETF, State Street's SPDR S&P/ASX 200 in 2001. Today that fund has $1.9 billion of funds under management.However, most ETFs have come along in recent times. The general manager of equity markets, at the ASX, Richard Murphy, says there were three ETFs listed in 2007, compared with 57 today.Because the Australian ETF market is young it has not yet seen the development of derivative-based (synthetic) ETFs, short-selling (inverse) ETFs, leveraged ETFs and other exotics common in US and European markets. There are even active ETFs.The two BetaShares ETFs that had, until this month, included some exposure to derivatives were the only two synthetic ETFs on the ASX.Exotic ETFsIt is the synthetic, inverse and active ETFs that are causing all the angst overseas. The concern is that these funds, which might have funds under management of billions of dollars, are being traded on an intra-day basis to capitalise on short-term index changes. They are magnifying volatility and they are putting a lot of people's savings at risk.A senior executive at the Australian Securities and Investments Commission, Gerard Patrick, says the types of ETFs causing concern overseas are not present in the local market.However, Patrick says anyone planning to invest in an ETF should get a clear understanding of how the product works before they do so.He says some of the ETFs offered here are so-called cross-listings, which means that money raised by the local ETF provider goes into a fund that is trading in an overseas market. Investors need to understand the regulations that apply in the market where that ETF will be doing its trading.Also, with any fund investing overseas, investors need to know how the currency exposure will be managed. Some funds hedge currency, other partially hedge and others don't hedge at all. Each approach changes the risk profile of the fund.The head of ratings at the funds research group Lonsec, Paul Pavlidis, says investors should look at a fund's tracking error (variance from the index) and its fees."ETFs are funds driven by systems, not by analysts picking stocks," he says. "You want to be sure the ETF provider has the resources to do the job efficiently."A manager whose tracking error is wider than its peers may not have the most efficient system. High fees, relative to comparable products, might also be an indication that the manager is not as efficient as it should be."Hilliard says some of the indexes used by ETF providers are "bespoke" - that is, they have been designed for the manager and are not widely used. On the local market there are several high-yield or high-dividend ETFs that use bespoke indexes.She says these can introduce risk in the form of tracking error and illiquidity.Counter-party riskPavlidis says the issue with synthetic ETFs is that the swaps or other derivatives used by the ETF provider bring a counter-party into the equation and, hence, another element of risk.The ASX's Richard Murphy says ETF listing rules in Australia limit derivatives in a synthetic ETF to 10 per cent of the value of the fund and insist that the collateral backing the derivative must be an asset that relates to the investment strategy of the ETF (there have been cases overseas where collateral of derivatives in ETFs has been high-risk securities, such as credit default swaps).The head of investment strategy at BetaShares, Drew Corbett, says synthetic ETFs have a place in the market and will become accepted as the market expands."We used synthetics in two of our ETFs as a way of reducing tracking error," he says. "The swaps we used were worth less than one per cent of the value of the funds."In our view there were benefits but we could see there were concerns about synthetics."Corbett says that as managers start introducing a wider range of ETFs, with exposure to commodity markets and emerging equity markets, such as China, they will have to use synthetics.How ETFs are taxedMost exchange-traded funds are managed funds traded on the Australian Securities Exchange.Buying and selling is done in the same way as listed shares.Tax arrangements are very similar to those that apply to unlisted managed funds: all income from dividends (in the case of an equity ETF) and capital gains are passed through to the investor. All tax is paid by the investor.Because almost all ETFs are based on an index and are passively managed, the portfolio turnover is usually low. This reduces the level of realised capital gains.Like other forms of pooled investment, ETFs may have embedded capital gains. What this means is that new investors may inherit a tax liability on unrealised gains for which they have received no benefit. This is a drawback.