Physical and Synthetic Exchange Traded Funds: the Good, the Bad or the Ugly?

Posted: 21 Mar 2012 Last revised: 21 Oct 2014

See all articles by Christian Meinhardt

Christian Meinhardt

Humboldt University of Berlin

Sigrid Mueller

Humboldt University of Berlin

Stefan Schoene

Humboldt University of Berlin

Date Written: July 24, 2014

Abstract

This paper focuses on the replication process of exchange traded funds (ETFs). It compares the tracking ability of ETFs based on physical replication of their benchmark indices to those of synthetic ETFs. Synthetic ETFs rely on derivatives such as swaps. For ETFs listed at the Frankfurt Stock Exchange we show that both categories of ETFs suffer from high tracking errors. Contrary to conventional wisdom, synthetic equity ETFs are not different in terms of tracking errors from their physical counterparts. However, synthetic fixed income ETFs have lower tracking errors than physical fixed income ETFs. Thus synthetic ETFs have as good or better tracking errors than physical ETFs. We identify different factors influencing tracking errors.

Keywords: Exchange traded fund, physical replication, synthetic ETF, tracking error, systemic risk, serial correlation

JEL Classification: G11, G12, G19, G23

Suggested Citation

Meinhardt, Christian and Müller, Sigrid and Schöne, Stefan, Physical and Synthetic Exchange Traded Funds: the Good, the Bad or the Ugly? (July 24, 2014). Journal of Investing, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2026409 or http://dx.doi.org/10.2139/ssrn.2026409

Christian Meinhardt (Contact Author)

Humboldt University of Berlin ( email )

Spandauer Str. 1
Berlin, Berlin 10099
Germany

Sigrid Müller

Humboldt University of Berlin ( email )

Unter den Linden 6
AK 10099
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++493020935601 (Fax)

HOME PAGE: http://www.wiwi.hu-berlin.de/finanz

Stefan Schöne

Humboldt University of Berlin ( email )

Spandauer Str. 1
Berlin, Berlin 10099
Germany

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