An ETF is an exchange-traded fund that replicates the performance of an underlying asset, such as a bond, index, commodity or basket of assets (e.g. an index fund). An ETF is not intended to outperform the market.
Physical ETFs replicate the target indices by purchasing the underlying securities that make up the index. There are two forms of replication:
(i) Firstly, holding 90% or more of the index.
(ii) Secondly, holding a representative sample of the index.
Synthetic ETFs track the performance of an index through derivatives. In this case, the intrinsic value of the ETF is not deducted from direct lines as in the case of physical ETFs but instead derives from a swap contract between the management company and a counterparty (often an investment bank). The counterparty is expected to provide the exact performance of the index that the ETF tracks.