Slightly off-topic: a lot of Vanguard's ETFs are synthetic. Is there anyone who can say something about the risk involved in this in contrast to non-synthetic ETFs?
Edit: As it turns out most or all of Vanguard's ETFs are physical.
ETFs, in general, involve greater risk (in addition to) than the underlying equity. In Singapore, average consumers (those without a background, or higher degree in Finance) are not allowed to purchase (even through their broker) an ETF without first having taken a series of course material, and exams. (pretty good idea if you ask me).
From the course, they highlighted synthetic replications risks as consisting of credit risk of the counterparty when swaps are used by the issuer to exchange, performance of the assets held by the ETF for the performance of the underlying index. Blackrocks' IVV [1] has a cost structure of 0.07%, which is pretty good - and does an extremely good job of tracking the S&P500. It uses, "Representative Sampling" - from their prospectus [2] BFA uses a representative sampling
indexing strategy to manage the Fund.
“Representative sampling” is an
indexing strategy that involves investing
in a representative sample of securities
that collectively has an investment
profile similar to that of the Underlying
Index. The securities selected are
expected to have, in the aggregate,
investment characteristics (based on
factors such as market capitalization
and industry weightings), fundamental
characteristics (such as return
variability and yield) and liquidity
measures similar to those of the
Underlying Index. The Fund may or may
not hold all of the securities in the
Underlying Index.
I traded ETFs and their synthetic equivalents professionally for about 6 months. Take this as an incomplete answer. As Zr40 said, they do have a large number of non-synthetic ETFs, so I'm not sure if they actually do use synthetic ETFs, but I'll address your question independent of whether or not they do.
A potentially major relative risk I can think of for synthetic ETFs vs real ETFs would be that it could diverge due to updates in the composition of the fund - particularly if a stock is removed or added. If the fund previously held a large position in a stock and decided to replace it, then that action will likely have a negative impact on the price of the stock, and you will only get knowledge of the fund adjustment the morning after or possibly later. This means when you readjust your synthetic position, you'll do so at inferior prices, which could hurt returns. Likewise, you'll probably buy new inclusions at a higher price. I saw this happen a couple of times - and usually within particularly volatile sectors with small cap companies where an ETF might come to hold a large chunk of a company.
That being said, I'd wager this effect doesn't outweigh the management fees charged for even the most frugal ETF, so creating it synthetically might be a good deal if you've got the manpower and cost structure to adjust your position regularly - or if you don't mind a bit of divergence. I'd be interested to hear other opinions on this as well.
Edit: As it turns out most or all of Vanguard's ETFs are physical.