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