An ETF is similar to an unlisted index mutual fund, or unit trust, in that it pools investments to purchase a diversified index asset base. However, the ETF adds the benefit of being traded on a stock exchange, so its shareholders can easily trade it at any time of the trading day at prevailing market prices. Unlisted funds can not offer this flexibility and are limited in how investors can buyand sell their shares.
In terms of structure, SPDR ETFs are physically replicated, which means the ETF buys the same securities as the index being tracked. This approach provides the investor with the comfort of owning the underlying assets. With physical replication, transparency is high and counterparty risk is limited.
Synthetic ETFs, on the other hand, do not hold the securities of the index they track; instead, they enter into derivative contracts, such as swaps, to execute their investment strategy. These derivative vehicles are agreements between the ETF and a counterparty — usually an investment bank — to pay the ETF the return of its index.
In comparing the two approaches, physically replicated ETFs have lower counterparty risk and higher transparency than synthetic ETFs.