Physically replicating and synthetic ETF – what is it?

Some ETFs replicate the exact securities in the index (fully replicating or physically replicating ETF). This method is suitable in liquid and developed markets. Other ETFs hold only a representative portion of the stocks in the index (replicating ETF with sampling method). This can be useful where a perfect replication of the index would not be cost-efficient.

Then there are ETFs that replicate the index by contractually buying the index return with a suitable counterparty via a derivative structure (synthetic ETF). The resulting counterparty risk again depends on how the derivative is collateralised.

As a matter of principle, we use physically replicating ETFs for our clients' portfolios, which actually buy and hold the shares or bonds. Only in the case of commodities do we currently make an exception (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 the majority of the fund assets as collateral in money market investments.

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