The tracking efficiency of physical and synthetic equity index ETF's

This paper evaluates the tracking efficiency of physical and synthetic Exchange Traded Funds (ETF’s). Theoretically, synthetic ETF’s should provide greater tracking efficiency. We study this using ETF’s domiciled in Europe tracking the European, the United States and Emerging Markets. We calculate the tracking error differences and use univariate analysis across both replication and regional strategies. Our contribution is in identifying the variables that influence ETF tracking efficiency. We find the total expense ratio remains the pre-eminent explanatory variable, but that the type of replication strategy is a significant secondary factor. We observe that the counterparty risk in synthetic strategies is not rewarded relative to physical replication strategies, but the synthetic ETF’s increase returns of tangency portfolios compared to physical ETF’s when analysed using mean-variance spanning techniques. This suggests investment in synthetic strategies is suited to risk tolerant investors and investment in physical strategies is more suited for risk averse investors.