Uncovering the subtlety of ETFs
Most exchange-traded funds (ETFs) are designed to deliver the risk and return of an investment index by replicating the performance of that index.
A FTSE 100 ETF, for instance, will aim to track the daily movements of the FTSE 100 index as closely as possible. Two main types of technique are used to replicate the index: direct, physical replication, whereby ETFs hold the underlying assets that are being tracked, and indirect, swap-based – which is often also referred to as ‘synthetic’ – replication, where the returns on the index are reproduced using swaps – a form of derivative.
This unofficial classification system is not fully informative, however. To better understand how ETFs work it is necessary to subdivide these categories further into full physical replication, partial physical replication with stratified sampling, partial physical replication with optimisation, funded swap-based ETFs and unfunded swap-based ETFs.
Full, direct physical replication involves buying and managing all the underlying constituent securities of the index being tracked. Managers of these ETFs have to trade their portfolio dynamically to keep up with changes to the index, which means transaction costs can affect tracking performance.
Partly to mitigate this, providers often engage in securities lending, which involves lending out the physical securities held by the ETF. This exposes the ETF to counterparty risk, or the risk that the counterparty on the lending deal will go bankrupt or for whatever reason will be unable to return the securities on time. To limit this risk, the lender (the ETF) demands that the borrower deposit collateral with a third party custodian bank. The idea behind this is if the counterparty fails then the collateral is liquidated in compensation to the fund.
Full physical replication can become difficult and/or expensive to implement when tracking broad indices that reference a high number of individual securities or when all or some of the underlying securities being tracked are relatively illiquid.
To overcome these problems, physical replication providers have developed tracking methods that involve only holding a portion of the underlying securities of the index. One method is called stratified sampling, which involves the ETF provider holding a selection of ‘representative securities’ only. This could entail splitting the index into, for example, sector-based subgroups, and then purchasing a sample of securities from each group. The choice of which securities will form part of the sample may be taken by the ETF manager or by a computer-driven, quantitative model.
The main advantage of this approach is reduced costs to the fund. But it can also increase the possibility of the fund experiencing relatively significant differences to the index it is tracking. For example, the ETF could have an unintentional bias towards holding large-cap stocks as part of the sample, which means if small-cap stocks outperform then the fund will fail to reflect the true performance of the broader index it is aiming to track. Also, exposure to the market in a physical replication ETF using stratified sampling will not be as diversified as the actual index itself.