Tracking Ability of ETFs: Physical vs. Synthetic Replication

Abstract

The purpose of this study is to examine the tracking ability of physical (in-kind) and synthetic (swap-based) Exchange Traded Funds (ETFs). By using three different measures of tracking error, I examine ten pairs of ETFs, which on aggregate track different asset classes (equities, bonds, commodities and foreign exchange rates), are sponsored by several investment companies and are listed on various stock exchanges. For consistency purposes though, each pair under review tracks the same underlying index/ asset, trades on the same stock exchange and is denominated in the same currency. The empirical results indicate that on average physically-replicated ETFs are over-performing their corresponding swap-based ETFs in terms of tracking ability. The findings indicate that there is a statistically significant difference in the tracking error of ETFs that employ physical replication and ETFs that employ synthetic replication. Hence, investors should consider the replication technique when they make their investment decisions concerning ETFs.

Keywords: Exchange Traded Funds, tracking ability, physical and synthetic replication, swap-based ETFs

JEL Classification: G19, G23