Physical vs. Synthetic ETFsSome background helps
One owns the shares, one owns a swap. The synthetic version is often the better tracker and always the more complicated claim — and the reasons are not the ones usually given.
Three ways to track an index
- Full physical replication — the fund buys every constituent in index weight. Simple, transparent, and expensive where the index is large or the market is hard to access.
- Sampled physical replication — the fund buys a representative subset. Cheaper to run, and it introduces sampling error that shows up as tracking difference.
- Synthetic replication — the fund holds a collateral basket and enters a swap with a bank: the fund pays the return of its basket, the bank pays the index return. The fund may own no index constituent at all.
How a synthetic fund actually works
$$ \text{Fund return} = \underbrace{\text{collateral return}}_{\text{what it owns}} + \underbrace{\big(\text{index} - \text{collateral}\big)}_{\text{the swap}} - \text{swap spread} $$
- The collateral basket is usually unrelated to the index. A fund tracking Japanese equities may hold European blue chips. That is not a scandal — the swap converts the return — but it is worth knowing before it surprises you.
- The swap spread is the bank's fee, and it can be negative: for some indices banks pay the fund for the exposure, because the trade helps their own book. That is how some synthetic funds beat their index net of fees.
- Counterparty exposure is capped by regulation in Europe at 10% of NAV per counterparty, and in practice most funds reset the swap far more frequently — daily or when exposure exceeds 1–2%.
- Fully funded versus unfunded structures differ in where the collateral sits: with the fund, or pledged in a segregated account. The second is stronger, and it is disclosed.
The comparison
| Physical (full) | Physical (sampled) | Synthetic | |
|---|---|---|---|
| What the fund owns | Every constituent | A representative subset | Collateral plus a swap |
| Tracking accuracy | Good | Sampling error | Usually the tightest |
| Counterparty risk | None from replication | None from replication | Capped and collateralised, not zero |
| Securities lending | Common — adds return and adds risk | Common | Usually none |
| Withholding tax on dividends | Paid, reduces return | Paid | Often avoided via the swap |
| Transparency | Highest | High | Holdings disclosed but unrelated to the index |
| Hard-to-access markets | Difficult, expensive | Difficult | The main use case |
| Complexity | Low | Low | Higher, and it must be read |
The tax advantage that drives most of it
- A physical fund holding US equities pays withholding tax on the dividends it receives. Depending on domicile and treaty, that is typically 15–30% of the dividend — on a 1.5%-yielding index, 20–45 basis points a year of permanent drag.
- A synthetic fund receives the index return through a swap rather than receiving dividends, and in several structures that return is calculated on a basis that avoids part of the withholding.
- This is the honest reason synthetic funds sometimes beat their index — not clever management, a tax treatment. It is legal, disclosed and it can be changed by legislation, which is a real risk to the advantage.
- The effect is largest on high-dividend, high-withholding markets and negligible where dividends are small.
Where each one is right
- Physical for broad, liquid, well-covered markets. The transparency is worth more than a few basis points, and the tracking is more than good enough.
- Synthetic for markets that are genuinely hard to hold — restricted access, high transaction costs, awkward settlement, or heavy withholding. This is where it earns its complexity.
- Synthetic for commodities and some strategy indices, where physical replication would mean storing metal or rolling futures inside a fund wrapper.
- Physical if you would not be comfortable explaining the counterparty arrangement to yourself. That is not a technical criterion and it is a reasonable one.
What to check on a synthetic fund's factsheet
- Who is the swap counterparty, and is there more than one?
- What is the collateral, and where is it held?
- How often is the swap reset, and what is the maximum exposure between resets?
- What is the swap spread — a cost, or a credit?
- Is the tracking difference consistent with all of the above? The decomposition tool answers this in one line.
Information and education only. Tax treatment depends on domicile, treaty and legislation, and changes. This page describes general structures for teaching purposes and is not advice, tax guidance, or a recommendation of any fund or replication method.