Replication methods: physical, sampling and synthetic

An ETF aims to track the performance of its index as closely as possible. There are three basic methods. Which one a fund uses is stated in its prospectus and key information document (KID).

Full physical replication

The fund buys all securities in the index at their index weights. This is common for indices with few, liquid constituents, such as the DAX or Euro Stoxx 50.

• Holdings match the index and are usually published regularly.
• Every index change and every reinvestment of dividends causes transaction costs.

Physical replication with sampling

For indices with a very large number of constituents or less liquid securities, such as MSCI World or MSCI Emerging Markets IMI, the fund buys only a representative selection. The aim is to reproduce the main characteristics of the index: countries, sectors, company sizes.

• Trading costs are usually lower than with full replication.
• The deviation from the index (tracking error) can be larger because not all securities are held.

Synthetic replication (swap)

The fund enters into a total return swap with one or more banks. The bank is contractually obliged to pay the index return; in exchange, the fund passes on the return of its own basket of securities or cash.

• Unfunded swap: the fund holds a basket of securities that may differ from the index and swaps its return for the index return.
• Funded swap: the fund transfers cash to the counterparty and receives collateral in return.

The basket is not arbitrary: it has to meet the diversification and liquidity rules of the UCITS Directive, and many providers publish its composition.

Swaps can give access to indices with hard-to-trade securities. For some markets, such as US equities, the tax burden on dividends can be lower than with physical replication, depending on the structure. Whether and to what extent this applies depends on the tax rules and the swap contract and can change. Swap fees are not always included in the TER; the tracking difference shows the combined effect of all costs.

Comparing the risks

Counterparty risk with swaps

If the swap counterparty defaults, the outstanding value of the swap is missing. The UCITS Directive limits the exposure to a single counterparty in OTC derivatives to 10 % of the fund’s assets if the counterparty is a credit institution, and to 5 % otherwise. Many providers reset the swap regularly and require collateral. A residual risk remains, for example if collateral loses value in a crisis.

Securities lending in physical funds

Physically replicating funds can also be exposed to counterparty risk if they lend securities for a fee. The extent, the collateral and how the income is shared between the fund and the provider are disclosed in the annual report and often on the provider’s website.

Transparency

With physical replication, holdings correspond to the index or a selection of it. With synthetic replication, the index exposure comes from the swap; the basket held can look very different from the index.

What to check

• Replication method, swap counterparties, collateral and securities lending are described in the prospectus, KID and annual report.
• The tracking difference over several years says more than the TER alone.
• Neither method is better in general. It depends on the index, the costs, the tax effect and your own assessment of counterparty risk.

Sources: Directive 2009/65/EC (UCITS Directive), in particular Art. 52; ESMA guidelines on ETFs and other UCITS issues (ESMA/2014/937).