Physical replication

A physically replicating fund owns the underlying securities. With full replication, it holds every constituent of the index in the index’s own weights, which works well for large, liquid indices of a few hundred or a few thousand stocks. With optimised or sampled replication, it holds a subset chosen so that the portfolio’s characteristics, such as its mix of sectors, countries and company sizes, closely match the index. Sampling is common for indices with thousands of small or illiquid securities, such as broad bond indices, where buying everything would be expensive.

The appeal is transparency: you can see what the fund owns, and there is no reliance on a swap counterparty to deliver the return. Physical funds still carry costs and risks. Sampling can cause tracking error, and many physical funds lend out their securities to earn extra income, which introduces a small risk that a borrower defaults and its collateral falls short. The fund’s reports should state how much it lends and how the revenue is shared. Physical is not automatically better than synthetic: for some markets a swap can track more closely or with less tax drag.