Physical or Synthetic: How an ETF Tracks Its Index
May 27, 2026
5 min read
Physical or Synthetic: How an ETF Tracks Its Index
The tax advantage of the synthetic version is real. So is its price.
The short version
- Physical means the fund actually buys the shares. Synthetic means it holds collateral and swaps that collateral's return with a bank for the index return.
- Synthetic can avoid US withholding tax entirely. On a world index with roughly 70% US weight that is in the order of 0.13% a year which a physical fund gives up.
- The price is counterparty risk and less transparency about what the fund actually owns.
- Physical funds are not risk-free either, because they may lend securities. Anyone claiming otherwise has not read the prospectus.
01The three constructions
Full physical replication. The fund buys every share in the index at the correct weight. The most transparent version, because the portfolio matches the index one to one. On very broad indices with thousands of holdings this becomes cumbersome.
Physical with sampling. The fund buys only a representative subset, usually the larger names, and omits the smallest. Cheaper to trade, at the cost of a small deviation from the index.
Synthetic. The fund holds some portfolio of securities as collateral and enters a swap with a bank: it gives away the return on its collateral and receives the index return. What actually sits in the fund often has little to do with the index — the contract is what matters.
02Why synthetic wins on tax
This is where it gets interesting, and where most guides stop.
A physical fund holds US shares and receives their dividends. The US withholds tax on those. With Irish fund domicile it is 15% instead of 30% under the double taxation treaty — the advantage we describe in detail elsewhere. But 15% remains.
A synthetic fund does not hold the US shares at all. It receives no dividends but a contractually agreed payment. Under certain conditions no US withholding tax applies to it.
What that means in numbers
A world index is roughly 70% US shares. At a dividend yield of 1.2% to 1.5% and the remaining 15% withholding tax, an Irish physical fund gives up around 0.13% a year. That is more than double the product costs of 0.06%.
Put differently: the largest single cost item in a physical world equity ETF is not the fee. It is a tax that another fund type does not pay.
03What the synthetic version costs
Counterparty risk. The index return comes from a contract with a bank. If the bank fails, the posted collateral steps in — but it is an additional layer that does not exist in a physical fund. UCITS rules limit this risk; they do not remove it.
Less transparency. Owning a physical world equity ETF means owning world equities. Owning a synthetic one means owning a collateral portfolio plus a contract. Both can work. Only one of them can be explained in a sentence.
Explainability in a crash. Not a technical argument, but a practical one. When the market falls 30% and someone wants to know what they actually own, "the fourteen hundred largest companies in the world" is an answer that holds. "A collateral portfolio and a swap contract with a bank" is not.
04Why we choose physical anyway
We could be roughly 0.13% a year cheaper. We are not, and that is a deliberate decision with a price attached.
The reason is not that synthetic funds are bad. Many institutional investors use them precisely for the US portion, and they have good arguments. The reason is that our entire construction rests on you understanding what you own — and therefore staying invested when it gets uncomfortable. The behaviour gap costs roughly 1% to 1.5% a year according to the available research. That is eight to twelve times what the synthetic version delivers.
So we trade a certain, small tax advantage for something that cannot be calculated. You may think that is the wrong call. But it is the trade-off behind the decision, and you should know it.
05What physical funds do too
A point almost no provider mentions: physical does not mean risk-free.
Physical funds may lend securities against collateral and earn from it. The fund we use may do so as well: according to the prospectus, equity index funds may have up to 50% of the portfolio on loan at any time, and at least 80% of gross revenue is credited to the fund, while the lending agent receives up to 20% for operational costs.
That is a side income which offsets part of the product costs. It is also the point at which even a physical fund has a counterparty. Secured by collateral, but not zero.
Anyone writing "physically replicated, therefore no risk" has not read the prospectus. We put it here because you will not find it anywhere else.
06How to tell which construction you hold
In the key information documentit says whether the fund holds or swaps the index constituents
In the name"Swap" or "Synthetic" with some providers, but not reliably
In the prospectussections on swaps, collateral and securities lending
In the holdings lista synthetic fund shows different names than the index
07Frequently asked questions
What is the difference between physical and synthetic?
A physical fund actually buys the index shares. A synthetic one holds a collateral portfolio and swaps its return with a bank for the index return. The outcome is meant to be the same; the route there is entirely different.
Is synthetic dangerous?
Not inherently. UCITS rules limit counterparty risk and require collateral. But a contractual relationship exists that a physical fund does not have, and it is harder to trace what the fund actually owns.
Why is synthetic more tax-efficient?
Because the fund holds no US shares and therefore receives no dividends subject to US withholding tax. Instead it receives a contractual payment which, under certain conditions, is not taxed. On a world index that is in the order of 0.13% a year.
Which is better for long-term saving?
Both work. Physical is easier to understand and involves no swap; synthetic is more tax-efficient on US-heavy indices. If you cannot explain the construction, you should not own it — which argues for physical.
Do physical ETFs lend securities?
Many do, and they earn from it. In the fund used here, at least 80% of gross revenue flows back into the fund. Lending is collateralised but still creates a counterparty. The actual amounts appear in the annual report.
Which construction does the arvy ETF Savings Plan use?
A physically replicating one, in every block. The funds hold the actual shares rather than tracking the index through a swap. That costs us roughly 0.13% a year in withholding tax which a synthetic construction would save — a deliberate decision in favour of traceability.
Keep reading
You should know what you own
Fully physically replicated, accumulating, Irish fund domicile — 0.39% management plus 0.06% product costs.
This article was written by Thierry Borgeat, co-founder of arvy, and reviewed by Patrick Rissi, CFA, and Florian Jauch, CFA.
Disclaimer: arvy AG is a manager of collective assets authorised by FINMA under Art. 24 CISA. This article is for information purposes only and constitutes neither investment advice nor tax or legal advice. All amounts are indicative and depend on canton, municipality and personal circumstances. Past performance is not a reliable indicator of future results.
