There are two main types of exchange-traded fund: physical and synthetic.
Ben Thompson, director of business development, listed products and ETF UK of Lyxor, says the difference between the two types of ETF is not as great as many might say.
Both start with a portfolio of physical assets, which is owned by the fund and held in a segregated account. Where the two types differ is in the role of these physical assets: one uses the physical assets for performance, the other for security.
However, Mr Thompson says even this is an overly simple explanation and there are many important techniques and strategies used by both types of ETF.
Full replication physically-backed funds purchase the stocks of the benchmark index in order to replicate the performance of the index, minus fees. As such, Mr Thompson says the holdings of the ETF must be the same, or very similar in proportion, to that of the benchmark index they track.
Purely physical funds work well for large, liquid markets where the component stocks or bonds can be easily purchased and traded. The ETF provider makes no attempt to optimise the fund’s performance or improve its tracking efficiency.
However, Mr Thompson says some indices are not so simple and can not be replicated by buying all the assets of the benchmark index.
In response, Mr Thompson says ETF providers have developed a number of alternatives to pure physical replication.
This might be the use of sampling techniques; whereby stocks which can’t be bought physically are substituted with larger, more liquid stocks. In general, a fund which utilises sampling would replicate the index in its sector weightings, but without holding every security.
In the case of very large indices such as the MSCI World index, which has more than 1,600 constituent stocks, Mr Thompson says buying all the stocks is inefficient and as such stocks with a small weighting may simply be ignored in the ETF basket.
In either case, Mr Thompson says as the ETF does not hold the same stocks as the index, sampling may lead to discrepancies in performance between the ETF and the index it is tracking.
Mr Thompson says a technique used by fund managers to improve the performance of a physical fund is to lend out the fund’s assets to other financial institutions. In return, the financial institution provides collateral against the stock and pays a fee for the service.
Mr Thompson says this practice is used throughout the asset management industry and it is called securities lending.
By reinvesting the revenues from securities lending, Mr Thompson says physical fund managers can improve the degree to which the ETF tracks its benchmark index.
“The risk is that the institution borrowing the securities could default, in which case the securities could be lost, and the fund value would suffer. However, with adequate collateral and tight management this risk can be significantly reduced.”