An Empirical Study on the Differences between Synthetic and Physical ETFs

Abstract

This research focuses on the differences between synthetic and traditional exchange-traded funds in benchmark replication process. It extends previous literature by empirical examining the tracking ability of traditional and synthetic ETFs traded at the Swiss Stock Exchange offered by the leading providers in Europe. 35 equity ETFs are used in the sample. For both types of funds the average tracking error is estimated in four ways. The research demonstrates that both traditional and synthetic ETFs have significant tracking errors. The findings also show that, contrary to popular opinion, synthetic ETFs have higher tracking errors than physical. These facts are of a significant importance to private investors and portfolio managers, especially if the performance of portfolio manager is based on a comparison to the performance of a benchmark.Additionally, factors that influence tracking errors are estimated. The results suggest that tracking errors are influenced by expense ratio, number of securities in the benchmark and type of replication for all estimation methods. Average daily trading volume doesn't influence dependent variables except for one tracking error estimation method.

Is the tracking error time-varying? Evidence from agricultural ETCs

“…According to Rompotis (2016), commodity exchange-traded funds (ETFs) using futures-based replication report a higher level of TE than physically replicated commodity ETFs. Naumenko and Chystiakova (2015) find that equity ETFs using swap-based replication lead to a higher TE compared with physically replicated ETFs. Accordingly, it is reasonable to expect agricultural ETCs also to report a high level of TE, since all the ETCs in our sample are replicated synthetically.…”

“…This limited attention from researchers on the tracking performance of ETCs also motivated us to conduct this study. Furthermore, the literature describes factors that affect the magnitude of this TE: management fees (Elton, Gruber, Comer and Li, 2002;Rompotis, 2006;, changes in index composition (Frino, Gallagher, Neubert and Oetomo, 2004), return volatility of the underlying index (Rompotis, 2006), bearish and bullish equity market conditions (Qadan and Yagil, 2012;Wong and Shum, 2010) and replication strategy (Drenovak and Urosevic, 2010;Fassas, 2014;Guedj, Li and McCann, 2011;Naumenko and Chystiakova, 2015;Rompotis, 2016). According to Chen (2015), the TE of commodity ETFs also differs depending on the bullish and bearish conditions in the equity market.…”

Exchange-Traded Funds on European Markets: Has Critical Mass been Reached? Implications for Financial Systems

“…To supplement the discussion of the possible influence of ETFs on the financial systems, and to justify our focus on ETF markets reaching the ‘critical mass’, it must be added that the minimum level of the size of ETF market, necessary for the emergence of either positive or negative outcomes, has still not been recognized. Nevertheless, the frequent assumption is that the probability of emergence of potential benefits or threats will increase with the increasing size of the ETF market (see, for example, [ 38 , 44 ]). However, this assumption was not verified empirically—even though there are a number of studies that examined the relationships between ETFs and particular linked assets (e.g., equities within the tracked stock indexes (see, e.g., [ 45 , 46 , 47 ]), including studies concerning the European ETFs, there were no previous attempts to check if the size of the local ETFs markets has reached the level that substantiates stating that they may exert sustainable influence on a broader scale.…”

Complexity of Innovative Financial Products: The Case of Synthetic Exchange Traded Funds in Europe

“…The authors describe the theoretical background and the results of empirical research on synthetic ETFs in such areas as tracking error and tracking costs (separately or compared to physical ETFs) [Maurer, Williams 2015;Naumenko, Chystiakova 2015], liquidity [Calamia, Deville, Riva 2013] and collateral risk [Hurlin et al 2014]. Nevertheless, the topic of ETFs' market development, its structure, dynamics and the influencing factors, as well as the risks for the financial systems has been rarely covered.…”