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ETF Solutions
Physical Replication vs. Synthetic Replication
Physical Replication vs. Synthetic Replication
As mostly passive investment instruments, ETFs are designed to mimic the returns of a benchmark index. The easiest way of accomplishing this is through physical replication, where the ETF manager simply purchases the underlying assets of the index whether they are stocks, bonds, or even gold bars. However, another popular method of index tracking is synthetic replication, where the ETF manager instead enters a swap contract with an investment bank that agrees to pay the index return in exchange for a small fee and any returns on collateral held in the ETF portfolio.
Physical Replication vs. Synthetic Replication
Tracking error is the term used to describe the deviation of an ETF portfolio's return from its benchmark index. The largest source of tracking error is generally the drag from expenses and tax withholdings on dividend payments. Also, caps on the weighting of securities from a single issuer can prevent the ETF from exactly duplicating the allocation of the benchmark index. In some cases, especially with indices covering fixed-income or emerging-markets stocks, the ETF manager will resort to sampling. Sampled portfolios do not hold some of the less liquid securities in their index, but the ETF manager tries to make the overall portfolio still mimic the benchmark index through judicious choice of holdings and perhaps some use of derivatives. Not all tracking error is negative; ETFs can lend securities to hedge funds and other institutions for short-selling and receive a fee in return.
Physical Replication vs. Synthetic Replication
Swap-based or synthetic replication ETFs have also gained popularity because they allow firms to promise the total return for a basket of stocks, including both the return from their price appreciation and the return from their reinvested dividend payments. The return on physical replication ETFs based on stock indices including foreign companies will often differ from the index return because of dividend withholding taxes that are only partially rebated after shareholders file their annual tax return.
Physical Replication vs. Synthetic Replication
While synthetic replication eliminates tracking error and reduces drag from dividend withholdings, it comes at the cost of counterparty credit risk. Because only the investment bank counterparty's creditworthiness guarantees the return on these ETFs, investors need to be comfortable with this exposure. Swap-based ETFs attempt to minimise credit risk by holding collateral to pay investors if the investment bank goes under, and also by using multiple counterparties.
Physical Replication vs. Synthetic Replication
In the European ETF market most providers use the synthetic replication method. However, the largest provider, iShares, uses the physical replication method, so investors have the benefit of choosing between the two methods in most asset classes, styles, and geographies.
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Physical Replication vs. Synthetic Replication
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