[Galanwe]

Index funds and ETFs also have strict replication rules limiting the amount of non-physical replication in their legally binding prospectus...

The more physical a tracker is, the lower the tracking error, but also the more fees you have to pay. "Good" ETFs/IFs are often 98% physical. This makes for higher fees, but more safety for subscribers in case of large swings.

So it's not like they are _free_ to replicate however they see fit, the replication mechanism is part of the product.

[hhh]

What does physical mean in this context?

[names_are_hard]

It means holding the actual stocks in the underlying index, as opposed to synthetic replication, which aims to achieve returns matching the index via derivatives or other techniques.

It's physical in the sense that literal means not literal nowadays.

[throwaway2037]

ETF and index arb traders use the term physical to describe securities that require full margin. Example: Sell stocks, buy index futures (and reverse) is the classic EFP equity trade. To be clear, futures are highly leveraged, thus do not require full margin.