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Comment by riffraff | Hacker News Reader

Index funds have a variety of ways to replicate the index beyond physical replication, including options, buying "similar things", sampling etc..

So yeah, they don't really need to stick to 100% of the presented issue.

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Index funds and ETFs also have strict replication rules limiting the amount of non-physical replication in their legally binding prospectus...

The more physical a tracker is, the lower the tracking error, but also the more fees you have to pay. "Good" ETFs/IFs are often 98% physical. This makes for higher fees, but more safety for subscribers in case of large swings.

So it's not like they are _free_ to replicate however they see fit, the replication mechanism is part of the product.

What does physical mean in this context?

It means holding the actual stocks in the underlying index, as opposed to synthetic replication, which aims to achieve returns matching the index via derivatives or other techniques.

It's physical in the sense that literal means not literal nowadays.

ETF and index arb traders use the term physical to describe securities that require full margin. Example: Sell stocks, buy index futures (and reverse) is the classic EFP equity trade. To be clear, futures are highly leveraged, thus do not require full margin.

Such a bold claim. Since we are talking about stock indices here... Can you provide a well known (liquid) non-leveraged example that does not directly trade the underlying stocks? It would probably make the create/redeem process more complex for market makers.

Invesco S&P 500 UCITS ETF

100% synth replication

edit: ISIN: IE00B3YCGJ38

Hat tip! I was not aware that Europe has very particular laws (different from the US) about how ETFs need to treat dividends. As a result, using an underlying equity swap is more tax efficient than owning the shares directly. For US-listed ETFs, I believe that my original point still stands: Well-known (liquid) non-leveraged ETFs hold physical shares instead of replicating returns with derivatives (equity swaps).

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