types of replication
ETFs, i.e. exchange-traded index funds, track an index, they replicate it. There are two ways to replicate the underlying index: physical replication and synthetic replication. Depending on the replication method, the provider takes a different approach to mapping the underlying index.
Physically replicating
A physical ETF replicates an index by actually buying the stocks contained in the index (direct replication). If the ETF provider (issuer) actually buys all the securities contained in the index, then this is considered a full replication designated.
Some issuers only buy and sell those stocks listed in the index that have a significant impact on index performance. That’s called representing sampling or optimized sampling. However, this approach can easily lead to deviations in the price development between the ETF and the index.
Synthetically replicating
Synthetically replicating ETFs don’t buy the stocks that make up the underlying index. They reflect the index development via barter transactions, so-called swaps. The swap transaction (also known as a total return swap) is a derivative transaction that is settled between the ETF provider and a swap counterparty. In practice, the ETF’s swap counterparty is often the parent company of the ETF provider.
The swap transaction works like this: the investor money in a synthetic ETF is invested in a basket of securities. This serves as security for the swap transaction. The securities in the collateral portfolio do not necessarily have to correspond to the securities in the replicated index. A synthetic ETF on the MSCI Europe can therefore also contain American equities in the collateral portfolio.
The swap counterparty pays the ETF the index return, including any dividend payments, in exchange for a fee (swap fee) and the return on the securities in the collateral portfolio.
What is better?
Synthetic replication is cheaper than physical buying and selling, but carries more risk than direct replication. If the swap counterparty defaults, investors may lose their entire deposit.