In brief: For index exchange-traded funds (ETFs), synthetic replication has recently gained equal footing with physical replication and, for tracking some indices, prominence at their expense. After briefly describing the two concepts, we compare them mainly from a taxation perspective. It turns out that synthetic replication can be more tax efficient in some cases, which may explain why it has achieved more widespread adoption even though physical replication could be more straightforward and easier to understand.
Over the 20 years that ETFs have been listed in Europe, investors have learned to understand and appreciate the two primary methods used to replicate an index. While ETFs using physical replication may have accounted for the lion’s share of assets in the early years, the synthetic replication model has gathered more acceptance in recent times. We’ve compared the two methods and find that synthetic replication can offer a structural advantage in some cases.
Synthetic replication appears to be gaining ground as the method of choice for passive index ETFs. Take, for example, Europe-listed ETFs that track the S&P 500: funds using synthetic replication accounted for nearly all of the USD 6.9 billion in net new assets in 2019 (figure 1). This is quite different from 2018, when synthetic and physical replication contributed more or less equally to asset growth.
Both synthetic and physical replication aim primarily to match as well as possible the performance of a specific reference index. The effectiveness of the replication method chosen can be measured by the tracking error (the volatility of the daily returns of the ETF versus the index) and tracking difference (the difference between the ETF’s return and the index return over time). Assuming perfect tracking, this tracking difference will be equal to the index return minus management fees. But, in reality, many ETFs will lag behind the index either by more than the amount of ongoing fees, or in some cases by less.
When structuring even the simplest passive product, an ETF issuer has several tools available, some of which depend on whether the index is going to be replicated physically or synthetically.
Full physical replication involves holding all the index securities in the same proportion as the index and rebalancing whenever the index does. Some physically replicating ETFs may use sampling techniques, which involves holding only a subset of the index that the portfolio manager hopes will offer a risk and performance profile similar to the index, but in a more cost-effective way than holding all the securities.
The second method is synthetic replication, which also involves holding a broad basket of securities, although not being limited to those of the index being replicated. The ETF issuer will have a list of securities it will accept into the basket. To match the index performance, the ETF uses swaps, whereby the swap counterparty agrees (via the derivative contract) to pay (or receive) any difference between the return of the index and the return of the basket of securities held.