Replication methods of ETFs

• Level: For beginners
• Reading duration: 2 minutes

The goal of each ETF is to replicate its index as closely and cost-effectively as possible. At the same time, the ETF investor receives all income from the securities in the underlying index. Therefore you participate in dividends and interest payments with ETFs.
 

How ETFs track their index

Various methods have emerged to replicate the index. The classic method is physical replication. If the ETF directly holds the all securities of the index, this is known as full replication.

However, full replication is not always possible. Thus, further procedures for replicating the index have emerged over time. Especially for very large, illiquid or international market indices, fully replicated ETFs reach their limits. Broad market indices are mostly replicated by computer-assisted optimisation methods that require fewer securities than the original index for replication (sampling).

Synthetic replication allows ETF investors to invest in new markets and investment classes. The ETF does not invest in the underlying markets, but only maps them. The ETF holds a diversified basket of liquid securities. Especially, costs, tax considerations and tracking quality led to the development of this replication method. Synthetic ETFs are able to replicate some indices more efficiently and better through swaps. Asset classes, such as commodities and the money market, were made investable via swap ETFs.

The following table shows the different replication methods in comparison.
 

Replication methods of ETFs in comparison