ETF essentials · 2 minute read
How does the ETF replicate its index?
The short answer
An ETF can follow its index by holding the investments directly or by using a financial contract with another institution. These approaches are known as physical and synthetic replication.
Why it matters
With physical replication, the ETF buys some or all of the investments in the index. It may hold every investment in the index or use a representative sample.
With synthetic replication, the ETF normally uses a swap or similar contract. The other institution, called the counterparty, agrees to provide the return of the index, subject to the terms of that agreement and relevant safeguards.
Neither approach is automatically better. The best approach can depend on the market being accessed, the cost of trading its constituents and how efficiently the ETF has followed its index.
A simple example
An ETF tracking a large, liquid stock market may be able to buy every share in the index. An ETF tracking a difficult-to-access market may use sampling or a swap to follow the index more efficiently.
The structure does not change the fact that the ETF remains exposed to the performance of the index. It can, however, affect operational and counterparty risks.
What to check
- Does the ETF use physical or synthetic replication?
- If physical, does it hold all securities or use sampling?
- If synthetic, who is the counterparty?
- What collateral (assets held as security) or other safeguards are described?
- How closely has the ETF followed its index?
The prospectus explains the ETF’s permitted replication methods and when derivatives may be used.
Key term explained
Replication is the method an ETF uses to deliver the performance of its chosen index.
Read the fund documents if you want to understand the structure in detail. The headline name alone will not tell you how the ETF operates.