Exchange traded funds track a multitude of assets, but there are a couple of different ways funds track any given market. For instance, an ETF could synthetically or physically replicate a benchmark.
To start off, passively managed physically backed, index-based ETFs hold either all the components of the index or a representative sample to reflect the performance of the underlying benchmark, Jose Garcia Zarate, a passive fund analyst at Morningstar, said.
For instance, something like a S&P 500 ETF would hold the 500 stocks that comprise the S&P 500 index.
On the other hand, synthetic ETFs try to mimic the performance of an index through derivatives such as swaps contracts. A swap is a promise from a counterparty, usually an investment bank, to replicate the performance of the market or index. Consequently, these types of ETF investments are said to be synthetically tracking an index.
For instance, many leveraged and inverse ETFs use swaps and derivatives to achieve their performance objective on a daily basis. [Making Sense of Physical and Synthetic ETFs]
Synthetic ETFs gained popularity, notably in European markets, as proponents argued that the swaps allows investors to more accurately track the underlying index. However, investors have grown increasingly concerned with synthetic ETFs due to greater awareness in counterparty risks raised by their securities lending activities.