Exchange Traded Funds
How do ETFs Track their Index?
ETFs track their underlying indices in one of three ways:
Replication – this means replicating the index exactly by buying exactly the same investments as those in the index in exactly the same proportions, re-balancing whenever the index is rebalanced.
Optimisation – this means seeking to track the index return by investing in a subset of the index constituents whose returns are judged likely to match those of the index as a whole.
Synthetic Replication – this means buying investments that may or may not be index constituents and entering into a “swap” transaction with the ETF’s sponsoring investment bank to swap the return on these investments for the return of the index. In other words, the ETF transfers to the swap counterparty the risk that the investments may not track the index and is assured of being able to deliver the index return to its own investors.
Replication may seem the most natural method of index tracking but it is not always practical. For example, in the UK it is possible to replicate the FTSE 100 Index which is made up of the biggest 100 companies since their shares are liquid and are easy to buy in the required quantities. However, this is less true of the broader and more representative FTSE All-Share Index which has nearly 700 constituents, many of which are comparatively illiquid smaller companies. Even optimisation is difficult in this case, so the ETFs that track the FTSE All-Share Index use replication.
Swaps are a well-established financial tool. However, the synthetic replication method is a form of financial engineering and introduces an element of counterparty risk should the counterparty to the swap default. This could put a small element of the ETFs assets at risk so it is important that the counterparty is strong and there is a regulatory obligation that an ETF’s swap counterparty risk should never exceed 10% of its net asset value. On the other hand, investment banks are often able to generate sources of supplementary revenue for themselves on the back of swap transactions, some of which they may share with the ETF through more generous swap terms. Therefore, the existence of the swap is capable of enhancing the underlying index return and offsetting the ETF’s management fees to some extent. Synthetic replication can sometimes also mean that an ETF does not pay dividends but simply rolls up its total capital and income return within its asset value so it is important that income-seeking investors ascertain whether or not this is the case.
