Is there difference in risk between physical or synthetic replication of an index by an ETF?

Question

I understand that there are different ways to manage an ETF. Some use physical replication where they seem to buy the actual stock to track the index it is following. Others use synthetic replication where they use options or swaps to do more or less the same.
I am interested in investing in ETFs, but I was wondering is there a difference in risk between the ETFs which use either physical or synthetic replication?
I can imagine that a 'plain' physical replication holds less risk then an ETF which uses other means.

Any thoughts?

Answer 1

First, make sure you understand the objective of an ETF. In some cases, they may use leverage to get a multiple of the index's return that is different than 1. Some may be ultra funds that go for double the return or double the inverse of the return and thus will try to apply the appropriate leverage to achieve that return.

Those that use physical replication can still have a small portion be used to try to minimize the tracking error as there is something to be said for what kind of tracking error do you accept as the fund's returns may differ from the index by some measure.

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Yes. For example, if you were to have a fund that had a 50% and -50% return in back to back periods, what would your final return be? Answer: -25%, which if you need to visualize this, take $1 that then becomes $1.50 by going up 50% and then becomes $.75 by going down 50% in a compounded fashion. This is where you have to be careful of the risks of leverage as those returns will compound in a possibly negative way.