Physical or Synthetic Replication in ETFs
Two different methods for the same goal, with different risk implications.
An ETF has to track the performance of an index — the method it uses isn't always the same, and understanding it helps you understand exactly what you're exposed to.
Physical replication
The fund actually buys (in full, or partly through sampling) the securities that make up the index. It's the most direct and transparent method: you indirectly own the real shares or bonds.
Synthetic replication
The fund doesn't hold the index's underlying securities directly, but instead tracks its performance through a financial contract (a swap) with a counterparty, typically an investment bank.
Counterparty risk
Synthetic replication introduces an additional factor to consider: the risk that the swap counterparty is unable to honour the contract. UCITS rules limit this risk (typically to 10% of the fund's assets), but it's a factor physical replication doesn't present in the same way.
Which to choose
For maximum simplicity and transparency, physical replication is generally preferred. Synthetic replication can offer a cost advantage or access to markets that are otherwise hard to replicate physically (e.g. some emerging markets).