
An exchange-traded fund (ETF) is designed to track or ‘replicate’ a broad-based market index, thus allowing their investors to gain exposure to that particular index and benefit from returns similar to that index.
There are two main methods ETF managers may employ in order to replicate the respective indices. The first method is known as direct replication, and ETFs that utilise this method are known as ‘cash-based ETFs’. ETF managers either fully replicate or do so via a representative sample. The second method is through the use of financial derivatives such as swaps or access products (e.g. participatory notes) and is typically used to track indices on restricted markets as they can’t be directly replicated. Such ETFs are known as ‘synthetic ETFs’.
Cash-Based ETFs
Full Replication
The ETF manager simply assembles a portfolio of assets that exactly resembles the underlying exposure of the benchmark index (identical constituents by proportion of their weights in the index).
Representative Sampling
The ETF manager selectively holds a number of constituents of the index that the ETF is tracking according to their degree of historical correlation with the respective index. This way, the ETF manager is holding a basket of the index’s constituents that best statistically represents the index itself. Certain market segments require ETF managers to employ representative sampling due to liquidity constraints.
Synthetic ETFs
Swap-based ETFs:
An ETF manager invests in a basket of securities and enters a swap with a provider to exchange the performance of the assets in the ETF against the performance of the underlying index. Swap-based ETFs thus have counterparty risks, should the swap provider defaults or goes into bankruptcy. However, the tracking error of swap-based ETFs are typically very low.
Derivative-embedded ETFs:
These ETFs basically invest in derivative instruments in order to replicate their respective indexes. These instruments include access products like warrants and participatory notes (P-notes) that are linked to the underlying securities constituting the index. These derivative instruments are issued by third parties, which means that, similar to swap-based ETFs, these sort of ETFs have counterparty risks should issuers of the access products fail to honour their commitments or go into default.
