ETF Replication Methods :
ETFs are simply designed to replicate the performance of their benchmark index. ETF Funds allows an investor to diversify their investment throughout the index with purchase of a single ETF share. With buying a piece of ETF share an investor is also eligible for the dividends and interest payments with ETFs.
While creating an ETF Fund that tracks Index, the investment management company have to take two major decisions, first is about the legal structure of the fund and another is the methodology which is to be used for the replication.
Most of the ETF Funds in the US are organized as unit investment trust and in Europe, ETFs are organized as open-end investment companies with UCITS (Undertakings for Collective Investments in Transferable Securities).
UCITS regulations enable investment funds to use financial derivative products. Whereas investment Company Act in the US limits most of the US-listed equity funds from using derivative products to track an index, they are restricted to use physical replication method.
The choice of legal structure and replication method decides that how precisely and accurately ETF Fund can track the benchmark index.
There are two popular methods that ETF providers used to reproduce the performance of an index:
- 1. Physical Replication
- 2. Synthetic Replication
Physical Replication :
Physical Replication is a traditional form of replication method and widely used in the US. It can be accomplished by holding all the securities of its target index in same proportion which is known as Full Replication or by purchasing largest index members having the major weightof an index, it’s known as Sampling Replication.
Full Replication mostly used when an index has the manageable number of securities and when the securities of an index are easy to bought and sold. Sometimes full replication is not technically or financially feasible. It is quite expensive in terms of commissions, especially for the large indexes containing hundreds or thousands of stocks.
At that time Sampling Replication comes into the picture, it is used when full replication is neither cost-efficient nor required to replicate the benchmark index.
Here the choices of underlying securities or stocks are made depending upon the market capitalization and index weightage of that particular security since it is not efficient to hold every individual stock in the index.
The advantage of using physical replication method is that it tracks its target index closely. Physical Replication is most transparent and easy to understand since the investor knows the nature of his investment and can track the composition of the index on daily basis.
Synthetic Replication :
Synthetic Replication Method is introduced in European financial market in the year 2001. It is introduced as an alternative to traditional Physical Replication Method.
Synthetic Replication is a process of replicating an index performance without holding underlying securities of an index. This method uses derivative products such as Swaps to achieve the desired results of the index tracking.
In Synthetic Replication, there is an involvement of Counterparty, such as Investment Bank. The ETF Fund and Counterparty (Investment Bank) enters into the swap agreement in which the counterparty agrees to provide the returns of an index to ETF Fund in exchange for performance of the collateral basket.
Synthetic method of replication comes with several advantages over physical method. It assures ETF fund manager the exact returns of an index since the counterparty agrees to pay it in SWAP agreement and hence the manager does not need to worry about the composition of an index.