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E xchange-traded funds (ETFs) are a popular vehicle to invest in an index at relatively low costs, thus serving investors' needs to diversify. Traditionally, ETFs replicate the index by investing in the assets that constitute the index. In contrast to these physical (replicating) ETFs, synthetic ETFs, introduced in 2001, are based on derivatives such as swaps and futures. More precisely, a synthetic ETF relies on a contract with a counterparty that pays the chosen index in exchange for a portfolio that the ETF is invested in. Usually, the partner of this swap is the financial institution to which the fund belongs. Because of this swap contract, synthetic ETFs face an additional counterparty risk.
What are the effects of the different replication techniques that are of interest to investors? Will there be a difference in tracking ability of the respective ETFs? Which factors influence the tracking ability of physical and synthetic ETFs? Generally, physical ETFs might suffer from transaction costs and illiquidity of their underlying assets, affecting their tracking error. Synthetic ETFs, on the contrary, can perfectly mimic the underlying index. Intuitively, this might result in smaller tracking errors of synthetic ETFs. This article addresses these issues for equity and fixed-income ETFs listed at the Frankfurt Stock Exchange, a major market for both kinds of ETFs. It also determines the factors that affect the tracking errors of physical and synthetic ETFs, respectively.
DATA
This study analyzes ETFs listed at the Frankfurt Stock Exchange from January 1, 2010, to August 31, 2011. We take the position of a European investor who trades in euro and does not want to bear exchange-rate risk. This yields a sample of 95 physical and 326 synthetic ETFs after excluding those ETFs suffering from a change in replication method or missing, incomplete, or incorrect data, respectively. Our sample comprises 286 equity ETFs, 117 fixed-income ETFs, and 18 other (commodity/total-return) ETFs on 315 different indexes.
Daily returns of ETFs and their indexes (based on closing trading prices), bid-ask prices, trading volume, dividends, and annualized total expense ratios (TER) are collected from Bloomberg and BlackRock, respectively. The information about replication method, asset class, corresponding index, and trading/index currency are hand-collected.
METHODOLOGY
Tracking Errors
In the literature, different measures of tracking error are used....