Physically replicating and synthetic ETFs - what is the difference?
Some ETFs replicate the exact securities in the index (fully replicating or physically replicating ETF). This method is suitable for liquid and developed markets. Other ETFs hold only a representative portion of the stocks in the index (sampling replicating ETF). This can be useful where a perfect replication of the index would not be cost effective.
Then there are ETFs that replicate the index by contractually purchasing the index return from a suitable counterparty via a derivative structure (synthetic ETF). The resulting counterparty risk again depends on how the derivative is collateralised.
In principle, we use physically replicating ETFs for our clients' portfolios, which actually buy and hold the shares or bonds. The only exception at the moment is commodities (otherwise the ETF provider would have to rent oil tankers and wheat silos). Here we use an ETF that replicates synthetically. It replicates the performance of commodities via derivatives and holds most of the fund's assets as collateral in money market investments.