Exchange traded funds come in many shapes and sizes, but at the core of the fund structure, investors are exposed to a physical basket of securities from a benchmark index or a synthetic basket that replicates a market.

Both physical and synthetic ETFs provide access to a specific market, but the two follow different methods, writes Holly Black for Interactive Investor. This is mostly an issue for ETFs listed outside the U.S.

Physical ETFs track an underlying index, like the Dow, S&P 500 or Nasdaq, by selecting shares from within the underlying index through a full replication technique or a partial, sampling technique.

A physical ETF is the “most vanilla way to track a bench,” Phil Reid, UK head of external distribution at HSBC, said in the article.

On the other hand, synthetic ETFs utilize swaps and derivatives to replicate the performance of the market. A swap is a promise from a counterparty, usually an investment bank, to replicate the performance of the market or index. For instance, many leveraged and inverse ETFs use swaps and derivatives to achieve their performance objective on a daily basis. [Understanding Synthetic ETFs, UCITs and Counterparty Risks]

While not as big in the States, synthetic products make up a large portion of the ETF market overseas, specifically in Europe.

Some argue that physical funds incur larger transactional costs due to portfolio rebalances, along with tracking error between the ETF and index. Synthetic ETF propoents believe that tracking errors can be avoided through swaps as the return is guaranteed to match the market. Meanwhile, synthetic ETFs have also made it easier to track less liquid or obscure markets.

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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