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December 7, 2020

Monday Morning Memo: Review of the Index Replication Methods Used by ETFs in Europe

by Detlef Glow.

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)

Replication Methods used by ETFs in Europe

Source: Refinitiv Lipper

Generally speaking, it is surprising that optimized replication is, based on the assets under management, the most widely used replication method in Europe. This is because one would expect that full replication would be in the leading position. A closer look at the general trends shows that the growth of optimized replication coincides with the growth in bond ETFs, which is no surprise given the structure of many bond indices which, for example, may often include bonds with a low liquidity. Therefore, optimized replication is the replication method of choice for the ETF promoter to overcome these weaknesses.

In more detail, full replication is the leading replication method for equity and commodities ETFs, which seems to be a bit contrary as investments in commodities are normally made through futures. However, since futures are not eligible for UCITS funds, ETFs do normally use swaps for the replication of commodities indices. That said, full replication is used in non-UCITS compliant precious metals funds domiciled in Switzerland which invest directly in the respective precious metal. Optimized replication is the most widely used replication method for bond and mixed-assets ETFs, while synthetic replication is the most widely used for alternative UCITS, money market, and “other” ETFs. It is noteworthy that synthetic replication is the only replication method that is used for all asset types.

Graph 2: Market Share of Replication Methods by Asset Type (October 31, 2020)

Replication Methods used by ETFs in Europe

Source: Refinitiv Lipper

If you look at the promoter level, it shows that full replication is used by the highest number of ETF promoters in Europe (41 out of 49), while 28 promoters also use optimized replication and 15 “other” replication methods. Meanwhile, only 13 of the 49 ETF promoters in Europe use synthetic replication.

An analysis of the average Total Expense Ratios (TER) shows that the average TER for synthetic ETFs was only at the end of October 2020 higher than the average TER for all ETFs in Europe, while it equaled the overall average TER at the end of 2019 and was lower than the overall average TER for the years 2015-2018. It is noteworthy that “other” replication methods, as one would expect, were on average the most expensive replication methods in the analysed period.

Graph 3: Average Total Expense Ratios (TER) of all ETFs vs. ETFs Using Synthetic Replication

Source: Refinitiv Lipper

With regard to the average TERs for the single asset types at the end of October 2020, synthetic replication was on average most expensive for equity, bond, and money market ETFs, and full replication was the most expensive replication method for alternative UCITS, commodities, and mixed-assets ETFs.

Graph 4: Average Total Expense Ratios (TER) by Asset Type and Replication Method (October 31, 2020)

Replication Methods used by ETFs in Europe

Source: Refinitiv Lipper

With regard to the above, only time will tell which replication method is preferred by investors in Europe. Given the fact that the move from iShares toward synthetic replication can be seen as a restart for this replication method, I would assume that we will witness an increasing market share for ETFs using synthetic replication in the future.

A wider use of synthetic replication does mean that the competition in the European ETF industry will increase as this means the investors will have another option to invest in a given market. For example, they will review the replication quality and the fees of the ETFs in their portfolio and opt for the best solution from their point of view. Therefore, the wider use of different replication methods should increase the overall product quality and may bring down the overall fees and expenses in the European ETF industry.

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Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.


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