Briefly summarized:
* ETFs can replicate a stock market index in different ways: physically or synthetically.
* Physical replication: This is a complete replication of the index. Physically replicating ETFs invest in exactly the same securities that are included in the respective index. The securities are also weighted exactly as they are in the index.
* Synthetic replication: In this form of index replication, investments are not made directly in the securities contained in the index. With synthetic ETFs, the index is replicated with a swap transaction - the total return swap.
* Advantages and disadvantages: While physically replicating ETFs are particularly transparent and therefore easy to follow, synthetic ETFs have the advantage of allowing investors to participate in markets that are difficult to access.
ETFs can replicate the index in different ways. There are two variants. On the one hand, there are ETFs with direct replication, known as physical replication. On the other hand, ETFs replicate stock market indices indirectly. This is known as synthetic replication. Both types have advantages and disadvantages.
Physical ETFs $EUNL (-1.03%)
With physical ETFs, investments are made directly in the securities listed in the index that is being tracked.
If a share is highly weighted in an index, it is weighted just as highly in the ETF.
If share A has a 10% share in the DAX, for example, the ETF must also weight share A with 10% if it exactly tracks the DAX.
However, this "complete replication" of an index is comparatively complex and cost-intensive. This is because the fund has to invest in each individual stock and constantly adjust the weighting depending on the market situation. This is particularly difficult when it comes to broadly diversified indices that include many shares.
The MSCI World contains more than 1600 stocks, the ACWI around 3000, and including them all in the ETF would be very difficult and costly. The index also contains illiquid stocks (*1), which are often not available to buy in the necessary quantities.
In such cases, sampling is often used.
Here, only the stocks with the greatest influence are bought and those with a low weighting are not included.
As a result, the ETF no longer tracks the original index one-to-one and the ETF performance may therefore differ from the index performance. This is also referred to as tracking error or tracking difference.
Synthetic ETFs $X010 (-0.93%)
A synthetic replicating ETF does not invest directly in securities that are included in the index. Instead, the benchmark is replicated with a swap transaction, a so-called total return swap (TRS).
The ETF provider concludes a contract with a SWAP partner. In most cases, this is the parent bank. In the case of Xtrackers, this is Deutsche Bank.
The partner bank undertakes to deliver the performance of the index, including all dividend payments, to the ETF. In return, the partner bank receives the return on a basket of securities that the ETF provider buys from the investors' money and deposits as collateral.
These do not have to be the securities contained in the index, but can be chosen at will.
An example: A collateral portfolio has a value of 100 million euros. If the underlying index rises by four percent, but the underlying portfolio only rises by two percent in the same period, the swap partner must pay the ETF the difference of two percentage points. In this case, this amounts to two million euros. If, on the other hand, the underlying portfolio outperforms the index, the bank pockets the excess return.
Synthetic replication is particularly useful for indices that contain a large number of stocks or where the corresponding shares are difficult to obtain. Synthetic replication ETFs are used almost exclusively for commodity indices, as it would be far too costly for the issuer to physically store all the commodities concerned.
However, one risk associated with synthetic replication is the possible bankruptcy of the partner bank if it is no longer able to meet its payment obligations and can no longer deliver the index return. The ETF provider must then fall back on the collateral portfolio and turn it into cash. However, if the value of this basket of shares is below the value of the index, investors incur a loss. According to the UCITS guidelines (*2), this risk may not exceed 10%.
The counterparty or default risk can also be reduced by the swap partner providing collateral itself. In the case of fully funded swaps, a special form of synthetic replication, the ETF invests exclusively in a swap and receives the index return in return for cash. There is no longer a carrier portfolio. The counterparty compiles the security basket and deposits it with a separate custodian bank.
Physical or synthetic?
There is no general answer as to which is better.
If you decide to invest in ETFs, you should consider which model of index replication you are more comfortable with. The construction of physical ETFs is much easier to understand. So if you follow the principle of "only buy what you understand", you will opt for this variant in case of doubt.
However, this does not mean that synthetic ETFs are worse. However, anyone who buys them should be aware that their equity portfolio often has little to do with the actual index.
*1 Illiquid shares are those that are only traded on the stock exchange to a very limited extent. These are usually very small companies that are not listed in any of the well-known indices (DAX, MDAX, etc.).
*2 UCITS Directive ("Undertakings for Collective Investment in Transferable Securities") $X010 (-0.93%)
