Synthetic vs Physical ETFs (UCITS): what changes, what doesn’t
Synthetic and physical ETFs can track the same index — but they do it with different plumbing. This guide shows the real risks (counterparty + collateral), what matters more (tracking difference + taxes + spreads), and a simple checklist for choosing safely.
- Physical ETF: the fund holds the underlying securities (directly, or via sampling).
- Synthetic ETF: the fund uses a swap to get index returns; risk is managed via collateral + UCITS rules.
- For most long-term investors, the bigger drag is not “synthetic vs physical”: it’s tracking difference, FX leakage, spreads, and taxes.
- Default rule: pick the ETF with the best tracking difference + liquidity, and understand the collateral policy if synthetic.
TL;DR
If you’re building a long-term ETF setup, your broker workflow and execution matter more than people think.
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What a physical ETF actually does
A physical ETF aims to match an index by holding the securities in the index. In practice, many ETFs use full replication (buy everything) or sampling (buy a representative subset) to reduce costs and handle large indexes.
- Upside: intuitive structure (you own a slice of the underlying basket via the fund).
- Main risk: normal market risk (prices move). Not “counterparty risk” in the swap sense.
- Hidden reality: securities lending may exist. It can add revenue but introduces additional operational risk (usually managed with collateral rules).
What a synthetic ETF actually does (swap-based)
A synthetic ETF tracks an index by swapping returns with a counterparty (often a large bank). Instead of holding the exact index basket, the fund holds collateral and receives the index return via a swap.
Two common structures
- Unfunded swap: ETF holds a collateral basket + swap overlays index return.
- Funded swap: cash is exchanged for collateral + swap return (less common in UCITS retail packaging; details vary).
What “risk” means here
- Counterparty exposure: what happens if the swap counterparty fails.
- Collateral quality: what the ETF holds as protection, how it’s valued, and how often it’s reset.
- Operational complexity: more plumbing, more rules.
UCITS rules generally limit and manage counterparty exposure and require collateral policies. Still: you should verify the ETF’s swap + collateral details in the KID/prospectus.
Synthetic vs physical: practical comparison
| Dimension | Physical ETF | Synthetic ETF |
|---|---|---|
| How it tracks | Holds securities (full or sampled) | Swap delivers index return; collateral backs exposure |
| Key “extra” risk | Securities lending (if used), operational risk | Counterparty + collateral management |
| Tracking quality | Can be excellent; depends on costs + sampling | Can be excellent; often strong for “hard” markets |
| What matters more in real life | Tracking difference, spreads/liquidity, FX leakage, and your ability to stay consistent | |
Risk reality check: what can actually go wrong
Most investors over-focus on the word “synthetic” and under-focus on repeatable leaks. Use this hierarchy:
- Liquidity + spreads: if you buy illiquid listings with wide spreads, you pay a tax every time. Read: liquidity, spreads, limit orders.
- Tracking difference: the ETF that “tracks better” wins long-run more often than the ETF that sounds cleaner. Read: tracking difference vs TER.
- Taxes and withholding: structure and domicile rules can dominate outcomes. Start here: US dividend withholding tax (non-US).
- Synthetic-specific: counterparty exposure + collateral policy — real, but usually controlled and disclosed in UCITS docs.
When a synthetic ETF can be the better pick
- Hard-to-access markets: where physical replication is expensive or messy.
- Better realized tracking: if the synthetic structure consistently delivers lower tracking difference (verify with data, not vibes).
- Cleaner operational outcome: some funds use swaps to reduce internal frictions (again: judge by tracking difference + spread).
Non-negotiable for synthetic
- Collateral policy is clear (type, haircut, valuation frequency).
- Counterparty exposure is limited and disclosed.
- You can find the prospectus/KID fast and confirm how it works.
Checklist: choose safely in 5 minutes
- Pick the index first: what do you want exposure to? (S&P 500, global, etc.)
- Compare tracking difference: don’t worship TER. Read: tracking difference vs TER.
- Check liquidity: volume/spread on your exchange; use limit orders. Read: spreads + limit orders.
- If synthetic: skim the collateral + counterparty section (prospectus/KID).
- Stop over-optimizing: pick one, automate contributions, and avoid switching.
CLUSTER
Related: costs, execution, and ETF “real return” leaks
The metric that matters more than marketing fees.
How to pick a world ETF (MSCI World vs FTSE All-World)
Avoid paying hidden execution taxes.
Choose the wrapper you can actually buy.
Understand tax drag before you optimize anything else.
Why small leaks dominate long horizons.
Risk control that doesn’t rely on predictions.
FAQ
Are synthetic ETFs “unsafe”?
Not automatically. The risk is different (counterparty + collateral), but UCITS frameworks and fund policies aim to control it. The practical decision should still prioritize tracking difference, liquidity/spreads, and taxes — then confirm the collateral policy.
Do physical ETFs always have lower risk?
Physical ETFs are simpler mechanically, but they still have operational risks (custody, securities lending, sampling). Your real-world outcome is usually dominated by market risk + costs + behavior, not the word “physical.”
What should I check first when choosing between two ETFs?
Start with tracking difference and liquidity/spreads. Then check taxes/domicile fit. If the ETF is synthetic, verify collateral/counterparty disclosures.
Is TER enough to decide?
No. TER is only one component. The number that shows reality is tracking difference (what you actually lose vs the index), plus execution costs (spread) and tax drag.
Want cleaner ETF research (listings, charts, alerts)? Use TradingView for research and keep execution at your broker.
Disclosure: We may earn a commission if you subscribe using our link. You never pay extra.
Educational content only. Not personalized investment advice.
Always confirm ETF structure details (swap/collateral, lending, domicile, fees) in the fund’s official documents. Your broker and residency can change what you can buy.
Educational content only. Not personalized investment advice.
Always confirm ETF structure details (swap/collateral, lending, domicile, fees) in the fund’s official documents. Your broker and residency can change what you can buy.