Physical ETF vs. synthetic ETF: what are the differences and which should you choose?

What is an ETF? 

An ETF is an investment fund listed on the stock exchange, traded in real time on financial markets just like traditional stocks. In particular, a passive or index ETF replicates the performance of a stock market index such as the CAC 40, the S&P 500, or the MSCI World. The main objective of a passive ETF is to faithfully reproduce the movements of its benchmark index, whether it rises or falls. 

Advantages of passive ETFs 

Passive ETFs offer several major advantages: liquidity, low management fees en instant diversification. They allow individual investors to access diversified index portfolios without needing to select each security individually. This passive approach contrasts with traditional active management, where managers aim to outperform the market through their investment choices. 

To learn more about ETFs, read our blog article on the topic. 

What is a physical ETF? 

Physical passive ETFs use the most intuitive approach: they actually hold the stocks that make up the indices they track. For example, if you invest in an ETF replicating the CAC 40, the fund effectively owns shares of LVMH, Sanofi, TotalEnergies, and all other companies in the index, in proportions that reflect their weight in the index. 

How physical replication works 

This replication method consists of reproducing the performance of an index by purchasing all or part of the securities it is composed of. Two methods exist: 

• Full replication: the fund holds all the securities in the index in the same proportions. This approach ensures very high accuracy but can be costly and complex to implement, especially for global indices containing several thousand companies. 

• Sampling replication: the fund buys only a representative subset of the index’s securities, typically the largest companies or those that drive most of the performance. Even though not all companies are held, statistical modeling makes it possible to faithfully reproduce the overall performance, including that of small caps. 

In the case of a global ETF like the one offered by Easyvest, sampling replication is preferred to limit transaction costs and optimize management. For the client, this does not result in any significant performance loss: the companies not directly held have such a small weight in the index that their impact is negligible, and the selection strategy ensures a very high correlation between the fund and its benchmark index. 

Advantages of physical ETFs 

Transparency is the main advantage of physical ETFs. Investors know exactly which securities they indirectly own. This clarity makes it easier to assess risks and understand the portfolio. This proves particularly useful in the context of an ESG investment strategy, for example, when the actual composition of the underlying asset is of special importance to the investor. 

Disadvantages of physical ETFs 

In physical ETFs, transaction costs and practical constraints related to holding securities can affect replication and generate performance deviations. Sampling, which is necessary for certain large indices, also introduces a potential deviation risk compared with the complete index. 

What is a synthetic ETF? 

Synthetic passive ETFs use a radically different approach. They do not specifically hold the shares that make up the index and offset the performance gap by entering into a derivative contract called a swap with a financial counterparty, usually a major investment bank. This counterparty agrees to deliver to the fund the exact performance of the benchmark index. 

How the swap works 

The swap operates as a performance-exchange contract. The synthetic ETF pays its counterparty the returns generated by the basket of stocks it actually holds (often different from the tracked index), and in return receives the exact performance of the benchmark index. This mechanism makes it possible to accurately replicate any index, even those that are difficult to access. 

Advantages of synthetic ETFs 

Synthetic ETFs provide two major advantages:

• Flexibility: synthetic ETFs make it possible to replicate complex investment strategies, for example in segments of the market that are illiquid or difficult to access. They can replicate indices of commodities, currencies, or sovereign bonds that are difficult to buy directly. This flexibility explains their success in certain specialized market segments. 

• Precision/Performance: synthetic replication often allows for more accurate tracking of the index because it avoids transaction costs related to buying and selling stocks; in some cases, it also helps avoid taxation. This is referred to as a lower “tracking error” compared with a physical ETF, or even in some respects better performance.  

Disadvantages of synthetic ETFs 

Synthetic ETFs may suffer from their complexity and relative opacity. Since the fund’s actual holdings differ from those of the index it replicates, investors do not always know exactly what they are investing in, even though they ultimately receive the desired performance. Furthermore, synthetic ETFs depend on the solvency of their swap counterparty(ies): in case of default, the ETF could incur losses. European regulation, however, requires that each counterparty represent no more than 10% of the fund’s net assets: this limits the risk but does not eliminate it. 

Physical ETF vs. Synthetic ETF: the showdown 

If we look at all the criteria discussed above, the comparison between physical and synthetic ETFs can be summarized in the following table: