The objective of the ETF is to generate returns that reflect the return of the underlying index as closely as possible. In the case of physical replication, the manager must update the fund portfolio to keep securities at the same weight as the index. Consequently, the fund’s return can deviate from the index (“tracking error”) due to transaction costs that arise when the manager has to buy and sell securities in connection with index reweighting and other corporate events, as well as during dividend season, when dividends received are reinvested in the index to reflect it as closely as possible.
Replication with derivatives can eliminate deviations from the index to a greater extent. Here, the fund shifts the responsibility to the derivative counterparty to provide the fund with its exact index return.
The ETF generates its exposure using OTC-derivatives
Funds that use synthetic replication can either invest in exchange-traded derivatives, usually futures, or in OTC-derivatives with specific counterparties. If the fund owns OTC-derivatives, these instruments are usually swaps. It is therefore common to call an ETF that generates its exposure using this type of instrument a “swap-based ETF”.
The more complicated an exposure is to replicate, the more advantageous it may be to use synthetic replication to minimise transaction costs and tracking error. For a fund that tracks a commodity index where, for example, crude oil, grain and electricity are included, it would in principle be impossible to apply physical replication. In this case, derivative-based replication is the only way it is practically possible to generate the exposure.