The main advantage of ETF

Full replication
With full replication, the fund provider goes out and buys the complete index list. All positions are bought in the correct ratio. Let’s say the index consists of 3 positions: Company A at 50%, Company B at 48% and Company C at 2%. Then the fund provider buys 50 shares of company A, 48 shares of company B and 2 shares of company C. These 100 shares then form the ETF.

The main advantage of this replication method: if things go to extremes and the ETF issuer becomes insolvent, then you own a share of quality shares that, in the worst case, you get booked into your own securities account.

Too little money is held – during a downward phase it is not possible to get rid of one’s shares. Check the site indexuniverse.eu and see all the ETFs or check Social Media:

The disadvantage: since the ETF is composed of „real“ shares, you have to deal with the problems and costs of the real world. Shares pay dividends, which have to be taxed, transferred and booked. That costs money and takes time. When the index is reshuffled, shares have to be bought and sold. That also takes time and costs money.

Optimised replication

In optimised replication, the fund provider looks at the index sheet before going on a shopping spree and decides, „Well, the 2% C doesn’t make much difference, I’ll leave it out.“ He buys 51 shares of A and 49 shares of B. These two shares now form the ETF. The advantage: by cutting out the mini-positions, the fund provider gets rid of a lot of work without significantly changing the fund’s performance. In reality, no provider will proceed as clumsily as I have done here in the example, but the goal is the same: How can I replicate the index sufficiently accurately enough with as few positions as possible?
The same applies here: even if the ETF provider goes bankrupt, there will still be quality stocks in the basket.
The disadvantages are not as strong as with full replication, but they are still there.

Synthetic replication

In synthetic replication, the fund provider doesn’t give a damn about the companies represented in the index; instead, it looks for an exchange partner, the so-called swap partner. In reality, this is often the fund provider’s parent bank. That’s why synthetically replicating funds are often called swappers.
The deal then goes like this: The fund provider puts whatever he wants in his portfolio, derivatives, shares, certificates, whatever. They then speculate and try to outperform the index.
The fund provider then delivers its result to the parent bank and receives the performance of the index in return. Let’s assume that the fund provider has turned 100 euros into 110 euros and the index has risen from 100 euros to 108 euros. If both now swap, the ETF provider gets its 108 euros, while the bank gets the 110 euros. If the ETF provider has speculated and only achieved 106 euros, they also swap. The ETF is then back at 108 euros and the swap partner has to make do with the 106 euros. The big advantage of swappers: since they do not trade in real shares but exchange their performance, the operational tracking error is zero. They are more accurate and cheaper than their replicating brothers. ETFs on exotic markets can often only be realised via synthetic replication.
Their disadvantage: one bears the counterparty risk. If the swap partner defaults, you are left with what the ETF has just bought. It is true that the swap risk is limited by law to 10 per cent of the fund’s assets. When a swap deal has grown to this size, its value must be settled in cash. Then a new swap contract is automatically started. In practice, funds usually stay well below the 10 percent limit, but the whole thing remains rather opaque for the investor.

 

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