• This note details how asset managers can use ETPs to emulate indices and asset baskets, optimizing their portfolios.
• The information is aimed at financial advisors and asset managers looking to meet their clients’ demands more effectively.
• FlexFunds offers an asset securitization program that creates ETPs to optimize investment strategies. For more information, feel free to contact our experts.

Exchange-traded products (ETPs) offer multiple benefits for asset managers and, therefore, for their clients. One of the most important is that they allow the creation of replication strategies to optimize investment portfolios.

Technical fundamentals of ETP replication

Replication through ETPs involves emulating the behavior of an index, asset, or asset basket as closely as possible. The goal is for asset managers (and investors) to achieve the same return (minus costs and certain adjustments) as the set benchmark.

Good replication helps reduce what is called tracking error and tracking difference with respect to the benchmark index.

Replication methods

When talking about replication, three methods are distinguished:

• Full physical replication: The ETP acquires all (or almost all) of the securities that make up the index, in proportions equivalent to their weighting.
• Sampling replication: When the index is very broad, has many components, or is illiquid, the ETP acquires a representative subset of the securities, optimizing costs and operations.
• Synthetic replication (based on swaps or other derivatives): The ETP does not directly acquire the index assets but enters into a total return swap contract with a financial counterparty that agrees to deliver the index return in exchange for a fee, while the ETP holds a collateral basket or other assets.

Advantages of replication through ETPs

Replication through ETPs offers several advantages for asset managers:

• Transparency and direct ownership: In full physical replication, the issuer buys the same assets of the index in the same weights, providing a high correspondence between the ETP assets and the index.
• Index tracking accuracy: A well-implemented physical replication method can achieve a reduced tracking error and low tracking difference. In synthetic replication, the use of swaps can allow for even higher tracking accuracy in certain difficult markets.
• Access to complex or illiquid markets: Synthetic replication allows the ETP issuer to offer exposure to markets or assets that would otherwise be too costly, hard to operate in, or illiquid.
• Liquidity and operability in secondary markets: A well-designed ETP with a solid replication structure can improve liquidity in the secondary market, facilitate creation/redemption of shares, and allow for smoother portfolio management for the ETP manager.

Operational challenges of ETP replication

• High costs in certain cases: In full physical replication, when the index contains many components or is frequently rebalanced, transaction costs, portfolio adjustments, and asset liquidity can be high.
• Counterparty and collateral risk (in synthetic replication): One of the main challenges of synthetic replication is that the structure depends on a swap counterparty. If the counterparty defaults, the ETP may not deliver the expected index return.
• Operational complexity and transparency: Some replication structures (sampling, hybrid, and synthetic) are harder for investors to understand, which can result in lower transparency.
• Regulatory risk: In adverse market conditions, synthetic structures may be affected by collateral stress, lack of liquidity in supporting assets, increased swap spreads, or even counterparty failure.

Synthetic replication and derivatives use: Implications on counterparty risk

Being a more complex structure, synthetic replication using derivatives can carry certain implications for counterparty risk.

In a typical total return swap structure, the ETP signs a contract with a counterparty that agrees to deliver the index return in exchange for a fee, while the ETP holds a basket of collateral assets (which does not necessarily match the index).

Counterparty risk arises because, if the entity acting as the counterparty defaults, the ETP may not receive the intended return, and the collateral may not fully cover the exposure.

To mitigate this risk, issuers often employ measures such as over-collateralization, multiple counterparties, daily swap settlement, collateral quality control, rules for eligible collateral, and hedging procedures.

For this reason, from a portfolio optimization perspective, the choice between physical and synthetic replication should be analyzed not only in terms of costs or tracking but also considering the overall risk profile of the portfolio, its horizon, counterparty risk tolerance, diversification of providers, etc.

The UCITS Directive: Regulatory framework and its influence on ETP structuring

The regulatory framework of the UCITS (Undertakings for Collective Investment in Transferable Securities) Directive forms the basis for the design, marketing, and supervision of investment funds and ETPs in Europe.

The most relevant principles for ETPs include:

• Transparency: UCITS funds must publish key documents that clearly describe the strategy, assets, costs, and risks.
• Diversification: Rules such as “5/10/40” limit risk concentration.
• Eligibility of assets and derivatives: UCITS must invest in “eligible” assets, and in the case of derivatives use, comply with reliable valuation, settlement, and supervised counterparties conditions.
• Liquidity and redemption: Open-ended funds must allow for the redemption of their shares by investors; ETPs traded on exchanges must comply with mechanisms that allow investors to obtain liquidity in cases of secondary market dislocation.
• Identification and marketing: UCITS that are ETPs must carry the “UCITS ETF” label or equivalent and disclose their replication method.

Flexibility and limitations of UCITS in choosing the replication method

The UCITS Directive does not prohibit the use of synthetic replication or derivatives, as long as the criteria (eligible assets, authorized counterparties, collateral, and transparency) are met.

However, there are limitations:

• The index being replicated must meet diversification, liquidity, and oversight criteria.
• In the use of derivatives, counterparty risk must be controlled, and collateral must meet quality, liquidity, and diversification criteria.
• Some complex exposures may not be able to be physically replicated within UCITS.

For the asset manager, this means that the choice of ETP under the UCITS regime involves considering the product’s internal structure. In other words, thinking about how replication is done and what counterparties, guarantees, costs, and operational impact it will have on the portfolio.

Performance measurement and attribution in different replication structures

Performance measurement and attribution vary according to the chosen replication structure:

• Tracking error (TE): Measures the consistency with which a product tracks its index. It is typically defined as the standard deviation of the difference in returns between the ETP and the benchmark index.
• Tracking difference (TD): Measures the accumulated return difference between the ETP and its index over a period (e.g., one year). It indicates the net performance gap.

Some of the main drivers of imperfect tracking, i.e., factors influencing TE and TD, include:

• ETP costs (management fees, spreads, and replication transaction).
• Liquidity of underlying assets.
• Frequency and magnitude of index rebalancing.
• Tax differences (e.g., dividend withholding).
• Replication method.
• Market events and counterparty risk.

Breakdown of performance by replication structures

For a portfolio manager that includes ETPs with different replication structures, it is useful to break down performance and tracking as follows:

• Index component: Return of the replicated index.
• Structural costs: Management fees, market spreads, transaction, collateral, and counterparty. This cost reduces the net ETP return versus the index, creating part of the TD.
• Operational deviation: Effects of sampling (if physical sampling), liquidity, execution timing, and collateral or swap spread (if synthetic). This affects both TE and TD.
• Counterparty/collateral risk (Synthetic): Although it may not manifest every year, an implicit “charge” should be assigned for this additional risk in portfolio valuation.
• Efficient replication benefit: In well-designed structures, lower TE can translate into a small “replication alpha,” which can provide an advantage for the investor.

As can be seen, ETP replication strategies are highly complex and require a team of experts to manage them.

At FlexFunds, a leader in asset securitization and ETP issuance, specialists are available to provide guidance.

To learn more about our products, please feel free to contact our executives. We will be glad to assist you.

Sources:

• https://wealthmanagement.bnpparibas.com/content/dam/wm-countries/luxemburg/wmlux/Legal_documents/INVESTOR%20GUIDE.pdf
• https://www.etfstream.com/education/essentials/etfs-tracking-error-vs-tracking-difference
• https://www.justetf.com/es/academy/etf-replication-methods.html
• https://etf.dws.com/es-es/AssetDownload/Index/6ee6a5b2-d799-4f7d-afa0-568c770bd08c/Xtrackers-guide-to-Synthetic-Replication.pdf
• https://www.morningstar.com/business/insights/blog/funds/etf-tracking-difference-error
• https://delano.lu/article/swaps-not-shares-tax-efficient-way-to-replicate-an-index
• https://www.ucits-etfs.com/guides/what-is-ucits-etfs/
• https://www.etf.com/docs/webinars/europe/HowWillRegulationAffectETFs.pdf
• https://www.esma.europa.eu/sites/default/files/library/2015/11/2012-832en_guidelines_on_etfs_and_other_ucits_issues.pdf
• https://www.nl.etfworld.com/esma-publishes-etf-guidelines-and-consults-on-repo-arrangements