What are physical ETFs?
Physical ETFs, also known as “physically replicated ETFs,” are exchange-traded funds that directly hold the securities or assets they are designed to track. In other words, these ETFs physically buy and hold the underlying assets in the index they are designed to replicate.
Here’s how physical ETFs work:
Direct Ownership of Underlying Assets: Physical ETFs purchase and hold the individual stocks, bonds, commodities, or other securities that make up the index they track. For example, if an ETF tracks the S&P 500 Index, it will buy all or a representative sample of the 500 stocks in that index.
Replication of Index Performance: By holding the underlying assets, physical ETFs aim to closely match the performance of the index they track, minus fees and expenses.
Transparency: Physical ETFs typically provide transparency into their holdings, allowing investors to see exactly what securities they own.
Creation/Redemption Process: Physical ETFs engage in the creation/redemption process, where authorized participants (APs) can create or redeem ETF shares by delivering or receiving the underlying securities. This process helps keep the ETF’s market price closely aligned with the net asset value (NAV) of its underlying holdings.
Lower Tracking Error: Physical replication generally results in lower tracking error compared to synthetic replication methods, where ETFs use derivatives to replicate index performance.
Physical ETFs are popular among investors who prefer transparency, direct ownership of underlying assets, and lower tracking error. However, they may have higher operational costs due to trading commissions, custody fees, and other expenses associated with owning and managing the underlying assets.
Lauren Hua is a private client adviser at Fairmont Equities.
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