Investing glossary
Physical vs synthetic replication
Physical replication buys the actual underlying assets of the index; synthetic replication uses a swap with a financial institution to replicate its return without owning the assets directly.
Physical replication is more intuitive and transparent (the fund actually owns the shares or bonds in the index), and today it is the predominant approach among large index ETFs.
Synthetic replication can achieve a lower tracking error for indices that are hard to replicate physically (for example, some emerging markets), but it introduces counterparty risk: if the entity on the other side of the swap were to default, there is an additional risk, though it is usually capped and collateralized under UCITS regulation.