Does the fund own what it tracks, and who else is holding it?
Two ways to build an index fund, and two places counterparty risk hides in one that looks like it has none.
Physical and synthetic replication
A physical fund buys the index's holdings — all of them, or a representative sample when the index is too long to hold in full. Every fund in this course's chart list is physical.
A synthetic fund holds something else — often a basket of unrelated liquid shares, or cash — and enters a swap with a bank: the fund pays the bank the return on what it actually holds, the bank pays the fund the return of the index. The swap is written to deliver the index return, and on an ordinary day it does so more closely than a physical fund can; what the holder actually receives is still net of the fee, the swap's own spread and whatever the counterparty fails to pay. Not one index share is owned.
Synthetic funds exist for good reasons: markets where foreigners cannot hold shares directly, indices of futures that are awkward to hold physically, and cases where the swap is cheaper than trading the basket. They also exist for a bad one, which is that the structure lets a fund carry a name that has little to do with what is in it.
Where the counterparty is
In a synthetic fund the bank on the other side of the swap owes the fund the index return. If the bank fails, the fund has its collateral basket and a claim, not the index. Regulation caps the exposure — UCITS rules limit uncollateralised swap exposure to 10% of the fund — and funds publish their swap counterparties and collateral daily. The risk is bounded and disclosed; it is not zero, and it is a bank's credit rather than the market's.
The other counterparty: securities lending
A physical fund has its own version. Most large trackers lend some of their shares to short sellers — the short-selling course's borrow, seen from the lender's side — against collateral, and collect a fee. The revenue is real: it is how a fund charging 0.10% can show a tracking difference smaller than 0.10%. The tracking lesson counted it on the fund's side.
The cost is that, for the duration of the loan, the fund holds collateral and a promise instead of the shares. If the borrower fails and the collateral has fallen, the fund is short. Funds publish how much they lend and how the lending revenue is split between fund and manager, and those two numbers are worth a minute: a fund that lends 30% of itself and keeps 60% of the revenue is running a lending business for its holders; one that lends the same and keeps 30% is running it for the manager.
Reading the structure
Three questions answer most of it. Physical or synthetic — the prospectus says, and a synthetic fund's holdings list will look nothing like its index. Who is the swap counterparty and how much is at risk — published daily by synthetic funds. How much does the fund lend and who keeps the fee — in the annual report of a physical one. None of this is a reason to avoid either structure. It is the difference between owning a fund and knowing what you own.
In the data
A fund's published holdings are the fastest test of replication: a fund named for one index whose largest holdings are something else is synthetic or sampled. The S&P 500 fund, then a fund of over six hundred developed-market shares outside the US:
The first list is the largest S&P 500 companies in index order, which is what a physical, fully replicated tracker looks like. Lending never shows in a holdings list; how much a fund lends, and who keeps the fee, is in its annual report.
Try it now
Read the names and weights in both lists above. Both funds are physical; one holds every constituent and one a sample, and the weights tell you which.
Now a synthetic fund on a European exchange: Invesco S&P 500 UCITS ETF, listed in London as SPXS, which delivers the index through a swap. Its ten largest holdings are below. Put them beside SPY's: which weights differ, and is every name even an S&P 500 member? On 28 September 2026 one was not — PDD Holdings, a Chinese e-commerce group listed in New York. Say why a list like this need not resemble the index the fund delivers.
- Write down the three questions from the reading section and answer them for one fund you actually hold or would. The third answer usually takes the longest to find, and that is a fact about disclosure, not about you.