The short version
- A physical ETF owns the shares in its index: either all of them (full replication) or a representative sample.
- A synthetic ETF uses a swap, a contract in which another firm agrees to pay the fund the index's return.
- Synthetic ETFs carry counterparty risk. UCITS rules cap a fund's exposure to any one bank at 10% of its assets.
- The factsheet tells you which method a fund uses. Look for "replication method", "methodology" or "product structure".
Part of ETF basics. New to ETFs? Start with what an ETF is and how it works.
- 10%most of a UCITS fund's assets that can be exposed to one bank in over-the-counter derivatives
- 1,224shares held by one sampled MSCI World ETF, against 1,277 in its index (31 August 2026)
- 0.05%yearly charge of one swap-based S&P 500 ETF, against 0.07% for the same provider's physical one
Three ways to track an index
Every index ETF has the same job: deliver its index’s return, minus costs. There are three main ways to do it.
- Full replication: buy every company in the index, in the index’s proportions.
- Sampling (or optimisation): buy enough of the index to behave like it, without holding everything.
- Swap-based (synthetic): hold other assets, and agree a contract that pays the index’s return.
The first two are both called physical, because the fund owns real shares from the index. ESMA’s guidelines group them the same way, as full or sample-based physical replication, alongside synthetic replication.
Full replication
A fully replicating ETF owns every company in its index. When the index changes, the fund changes with it.
This works best when an index has a manageable number of large, easily traded companies. The iShares Core FTSE 100 ETF lists its methodology as “Replicated”. So does SPDR’s S&P 500 ETF, which tracks an index of 503 companies.
The advantage is simplicity: you can see that the fund holds what the index holds. The cost is trading every small company, every time the index changes.
Sampling
Some indices hold thousands of companies, many of them small or hard to trade. Buying them all can cost more than it’s worth.
So many funds hold a sample. HSBC’s MSCI World ETF explains that it uses optimisation, balancing tracking error against trading costs. It won’t necessarily hold every company in the index, or hold them in the same proportions.
At 31 August 2026 that fund held 1,224 companies, against 1,277 in its index. Vanguard says its FTSE All-World ETF invests in a representative sample of the index’s shares. The iShares Core MSCI World ETF lists its methodology as “Optimised”.
The trade-off is a little more tracking error, meaning month-to-month returns can wander slightly further from the index. The ETF costs guide explains tracking difference and tracking error.
Swap-based ETFs
A synthetic ETF gets its return from a swap. In a total return swap, the fund agrees with a counterparty, such as a bank, that it will be paid the index’s return.
The fund still owns assets, such as a basket of shares, which can differ from the index. The swap exchanges their return for the index’s.
The iShares S&P 500 Swap ETF is an example. Its factsheet lists its product structure as “Synthetic” and its methodology as “Swap”. Its top holdings show the swap on the S&P 500 alongside individual company shares.
The factsheet also warns that tracking the index relies on the counterparties continuing to pay the index’s performance. That’s the trade-off at the heart of a synthetic fund.
Cost can be one difference. iShares’ swap-based S&P 500 ETF charged 0.05% a year, against 0.07% for its physical Core S&P 500 ETF.
Counterparty risk and the UCITS limits
The risk in a swap is that the counterparty fails and doesn’t pay what it owes. UCITS rules limit this in several ways.
- A cap: exposure to one counterparty in over-the-counter derivatives can’t exceed 10% of the fund’s assets if it’s a bank, or 5% otherwise.
- Counted together: exposure from swaps and from securities lending (lending the fund’s shares for a fee) counts towards the same limit.
- Collateral: assets taken as security must be highly liquid, valued at least daily, high quality, diversified and independent of the counterparty.
- The basket counts too: where a fund uses an unfunded swap, the shares it holds must still meet UCITS diversification limits.
- Disclosure: the prospectus must describe the counterparty risk, and the annual report must name the counterparties and the collateral received.
Physical funds aren’t free of counterparty risk either. A physical fund that lends its shares relies on the borrower and the collateral. The iShares FTSE 100 factsheet lists counterparty risk among its key risks, even though the fund is physical.
The guide to ETF safety covers what happens if a provider or platform fails.
How to tell which method a fund uses
Providers have to tell you. ESMA’s guidelines require an index fund’s prospectus to say whether it uses full physical, sampled physical or synthetic replication. It must also explain what that means for counterparty risk. A summary must appear in the key investor information document.
The factsheet is the quickest place to look. The labels vary by provider:
| Factsheet example | What it says |
|---|---|
| iShares Core FTSE 100 | Product structure: Physical. Methodology: Replicated |
| iShares Core MSCI World | Product structure: Physical. Methodology: Optimised |
| iShares S&P 500 Swap | Product structure: Synthetic. Methodology: Swap |
| HSBC MSCI World | Replication method: Physical- Sample |
| SPDR MSCI All Country World Investable Market | Replication method: Optimised |
The name can help too. A fund with “Swap” in its name, like iShares’ S&P 500 Swap ETF, is likely to be synthetic. But don’t rely on the name alone: check the factsheet.
Weighing it up
Neither approach is better in every case. Each swaps one set of risks and costs for another.
- Is it important to you that the fund owns the actual shares in the index?
- How do you feel about relying on a bank to deliver the return, within the UCITS limits?
- What does the tracking difference show over several years, after all costs?
- Does the fund lend its shares, and if so, how is that income shared?
Common questions
- Are synthetic ETFs riskier?
- They carry a risk physical funds mostly avoid: that a swap counterparty fails. UCITS rules cap that exposure and require collateral, so the risk is limited, not zero.
- If a swap counterparty fails, do I lose everything?
- No. The fund still owns its basket of assets, and exposure to any one bank is capped at 10% of the fund’s assets.
- Does a synthetic ETF own anything?
- Yes. It holds assets, such as a basket of shares, which can differ from the index. The swap exchanges their return for the index’s.
- Can I hold a synthetic ETF in an ISA?
- Yes, if it’s eligible. iShares’ S&P 500 Swap ETF factsheet, for example, lists it as ISA and SIPP eligible.
- What’s securities lending?
- Lending some of the fund’s shares to other firms for a fee, against collateral. Under ESMA’s guidelines, the revenue, minus operating costs, must go back to the fund. The fund must also be able to recall the shares at any time.
This page explains how ETFs track their indices. It isn't advice about what you should buy. Investments can fall as well as rise, and you may get back less than you put in. Read the full disclaimer.
Sources
- Guidelines on ETFs and other UCITS issues (ESMA/2014/937), European Securities and Markets Authority
- Directive 2009/65/EC (UCITS), Article 52, EUR-Lex
- iShares Core FTSE 100 UCITS ETF factsheet, September 2026, BlackRock
- iShares Core MSCI World UCITS ETF factsheet, September 2026, BlackRock
- iShares Core S&P 500 UCITS ETF factsheet, September 2026, BlackRock
- iShares S&P 500 Swap UCITS ETF factsheet, September 2026, BlackRock
- HSBC MSCI World UCITS ETF monthly report, 31 August 2026, HSBC Asset Management
- FTSE All-World UCITS ETF (USD) Distributing, Vanguard
- SPDR S&P 500 UCITS ETF (Dist) factsheet, September 2026, State Street Investment Management
- SPDR MSCI All Country World Investable Market UCITS ETF factsheet, 30 September 2026, State Street Investment Management
Facts checked 13 October 2026.