Review Of The Index Replication Methods Used By ETFs In Europe

 

After iShares, the largest ETF promoter in Europe, returned to using synthetic replication with the launch of a swap-based ETF on the S&P 500, I published my views on this move in the Monday Morning Memo called “A New Dawn for Synthetic ETFs in Europe”. I believe this move might be a game changer regarding the usage of synthetic replication in the European ETF landscape.

A brief review of the historic trends around the usage of replication methods in the European ETF industry shows that synthetic index replication was widely used in the European ETF industry up until 2011. This is because investors appreciated the low tracking error and, in some cases, higher performances of these products compared to ETFs which used so-called physical replication. But in the aftermath of the financial crisis and the euro crisis, critics argued that ETFs that use a swap to replicate their underlying indices add another layer of risk to their portfolios. With the developments during the financial crisis in mind, investors started to divest from synthetic ETFs and invested in physical ETFs which replicate their index by either holding all the constituents of the index with the respective weight in their portfolio (full replication) or, for indices with a large number of constituents or very complex/exotic indices, a basket of securities that matches the risk/return profile of the index (optimized replication). The preference for physical replication can clearly be seen in the market shares, measured by assets under management, for the respective replication methods.

As Graph 1 depicts, ETFs which were using physical replication held 84.28% (42.12% full replication, 42.16% optimized replication) of the overall assets under management in the European ETF industry at the end of October 2020. Meanwhile, synthetic ETFs accounted for only 14.11%.

Graph 1: Market Share of Replication Methods by Assets Under Management (October 31, 2020)

(Click on image to enlarge)

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