Physical and Synthetic Exchange-Traded Funds: The Good, the Bad, or the Ugly?

Abstract

This article focuses on the replication process of exchange-traded funds (ETFs). It compares the tracking ability of ETFs based on physical replication of their benchmark indexes to those of synthetic ETFs. Synthetic ETFs rely on derivatives such as swaps. For ETFs listed at the Frankfurt Stock Exchange, we show that both categories of ETFs suffer from high tracking errors. Contrary to conventional wisdom, synthetic equity ETFs are not different in terms of tracking errors from their physical counterparts. However, synthetic fixed-income ETFs have lower tracking errors than physical fixed-income ETFs. Thus, synthetic ETFs have as good or better tracking errors than physical ETFs. We identify different factors influencing tracking errors.