Generally speaking there are two ways how an ETF can replicate its underlying index. The first is the so-called physical replication, where the ETF holds the actual securities in its portfolio. The second is the so-called synthetic replication where the ETF normally holds a total return swap and a set of in-kind securities as collateral. Both replication methods have their strengths and weaknesses which will be unveiled in this article.   ETFs that use physical replication can do so in two different ways:   Full Replication: The ETF holds all securities of the underlying index in the exact proportions as

Up until 2011, synthetic index replication was widely used in the European ETF industry and investors appreciated the low tracking errors and, in some cases, higher performances of these products compared to ETFs which used so-called physical replication. But in the aftermath of the financial crisis and the euro crisis, critics argued that ETFs that use a swap to replicate their underlying indices add another layer of risk to their portfolio. With the developments during the financial crisis in mind, investors started to divest from synthetic ETFs and invested in physical ETFs which replicate their index by either holding all