ETFs are designed to mimic their benchmark index, one of the simplest way to accomplish that is buying all the underlying securities of an index or representative sample. This method is known as Physical Replication and the ETF is known as Physical ETF.
There are two types of Physical Replication :
- 1. Full Replication
- 2. Sampling Replication
Full Replication means buying all securities of an Index in a similar weightage as securities have in the index to form an ETF Fund. For example, ETF designed to track the performance of the S&P 500 Index, then the fund manager will have to buy every single security of an S&P 500 Index in the same weightage as they have in the index.
Full Replication is one of the most transparent method of replication. The downside of this method is that it's more expensive to the investor since buying and selling of securities is huge hence it charges higher management fees.
Physical ETF Function
If there are huge number of securities present in the Index then the securities that hold sufficient liquidity will be acquired by ETF, it is known as Sampling ETF.
Sampling Replication is used when buying every single security of an index is impossible and also inefficient. For example, If the index to be replicated is consist of more than 2000 securities then it is almost impossible to buy all securities of an index.
By avoiding the securities which are illiquid,having low index weightage and does not have any major impact on fund performance, the fund can significantly reduce the cost. Sampling ETFs generally suffers from tracking errors and to reduce the tracking error the securities that have the high correlation to the performance of reference index are added to the ETF Fund.
Note: It has been observed that iShares commonly uses Physical Replication Method.