What is Physical and Synthetic Replication?

Replication is the means by which the ETF gives you the exposure of the index.

Physical replication is the most straightforward – the ETF will directly own the stocks or bonds that comprise the index.

In some cases, the index construction makes it hard or expensive to buy all of the underlying securities and an ETF may need to be synthetically replicated. Instead of owning the underlying securities, the index performance will be delivered by a financial derivative provided by an investment bank (called a swap).

Pros and Cons of Physical Replication

Physical replication is the most common way for an ETF to replicate an index. It gives the investor comfort to know that they own the underlying shares or bonds inside their ETF.

However, for some ETFs that hold hundreds or thousands or securities, physical replication may not be the best approach. The trading costs of buying 1,000 or more securities might have a negative impact on the ETF, and in some markets where there are foreign ownership restrictions or less liquid securities (like some emerging markets, or portions of the bond markets) there may not be the inventory available to meet demand for the ETF.

In these cases, an issuer may choose to either use an optimization or sampling approach. Instead of buying all the securities in the index, they try to replicate the index closely but with fewer securities. Another alternative is to take a synthetic replication approach.

Pros and Cons of Synthetic Replication

Synthetic replication is when a bank provides a pay-off pattern that is identical (or close to identical) to that of an index – normally via a swap. This is a great way for investors to access the returns of a basket of securities that they may otherwise not be able to own, due to market access issues, illiquidity in the underlying asset class or restrictions on foreign ownership.

The trade-off is that the return pattern is delivered by a bank, not the underlying securities and so investors are exposed to the counterparty credit risk of the swap issuer. In the event of that issuer going bankrupt, the investor may not be able to get all or any of their money back, even though the swap is often collateralized to some extent.