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Physical or synthetic

A fund can follow its index by owning the shares, or by a contract with a bank that pays the index’s return.

Physical

A physical fund buys the shares in the index. With a big index it may buy a large sample instead of every one. What you own is a slice of real companies, held by the fund’s depositary.

Synthetic

A synthetic fund owns a basket of other assets and has a contract (a swap) with a bank that pays the index’s return in exchange. It can follow some indexes more cheaply, or save tax on some dividends.

The extra risk

If the bank fails, the fund keeps its own basket but may lose what the bank owed. EU rules cap what a fund may be owed by one bank at 10% of its value, and most swaps are reset often to keep it smaller.

Lending shares

Physical funds may lend shares to others for a fee, against collateral. It earns a little and adds a small risk. The fund’s website shows how much is lent and what it holds as collateral.

Key takeaways

  • Physical funds own the shares; synthetic ones own a contract.
  • Synthetic adds a capped risk on the bank behind the contract.
  • Both can follow an index closely; compare cost and tracking.