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]