Full vs. Synthetic Replication and Tracking Errors in ETFs

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The growth of passive investing and ETFs is indisputable. Consequently, this boom also affects financial markets (e.g., market elasticity or by creating predictable buys and sells) and assets that ETFs track. Even though all passive ETFs aim to replicate some benchmark index, there are two distinct approaches to doing so. The first approach is directly replicating the benchmark (by buying underlying assets) either by full direct replication or sampling. The second approach consists of synthetic replication using derivatives – most commonly by total return swaps (or futures). 

The investor is interested primarily in the tracking error (and perhaps in counterparty risk in synthetic ETFs), which is the leading research topic for the novel paper by Zheng (2021). Since synthetic replication is more spread in Europe, the author examines equity and fixed-income ETFs during 2001-2020 and studies how the replication method affects the tracking error. 

The first finding is that there is no significant difference in the tracking ability across the whole sample period. However, the global financial crisis was a structural break, after which the tracking errors were reduced. The synthetic equity ETFs seem to have a better tracking ability and lower sensitivity to market turbulence after the crisis. Additionally, synthetic ETFs have more substantial tracking errors after a sudden increase in counterparty risk but are less affected by liquidity shocks than physically replicated ones. The author has also identified that there have been crucial improvements in risk management of swap counterparty risk over the past decade. 

Overall, the paper offers several insights and an essential comparison of physical and synthetic ETFs. Understanding the synthetic ETFs can be crucial for investors since it is commonly utilized to track less liquid or developed markets and appears to be more tax-efficient. 

Author: Xinrui Zheng

Title: Does the Replication Method Affect ETF Tracking Efficiencies?

Linkhttps://papers.ssrn.com/sol3/papers.cfm?abstract_id=3962470

Abstract:

Using 2,290 European equity and fixed income ETFs from 2001 to 2020, this paper studies how replication method affects the tracking efficiencies of ETFs, especially during market crisis. There is no persistent evidence suggesting superior tracking performance of synthetic ETFs relative to physically-replicated ones. I identify 119 indices simultaneously tracked by both physical and synthetic ETFs, and conduct difference-in-difference analysis around Lehman Brothers bankruptcy, sovereign debt crisis, and COVID-19 outbreak. Synthetic ETFs face steeper declines in tracking efficiencies after a sudden increase in counterparty risk, but they are shielded from liquidity shocks. There is a remarkable drop in the sensitivity of tracking performance to market distress measures after the global financial crisis.

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