This term paper will mainly focus on ETFs tracking equity markets. The low costs, the simplicity of the product and the broad range of different ETFs available are the reasons why the assets under management (AUM) in the ETF industry grew by 20%2 p.a. in the last 15 years, with a continuing upward trend.
This term paper is divided into two parts. The first part will start with explaining some basic characteristics of ETFs. Thereafter, different structures behind ETFs are described and factors influencing the tracking difference are analysed. In the second part of the term paper, two ETFs are compared. While one of them uses the physical replication method and the other the synthetical replication method, both of them cover the MSCI World Index. The ETFs are compared with regard to some basic information about them, but mainly concerning the tracking difference occurring from the different replication methods and other factors influencing the performance of the funds.
Table of Contents
1 Introduction
2 Structuring ETFs
2.1 ETFs as a product to track the performance of an index
2.2 Structures fund companies use to build ETFs
2.3 Factors influencing the tracking difference
3 Comparison of two ETFs tracking the MSCI World Index
3.1 MSCI World Index
3.2 iShares Core MSCI World UCITS ETF
3.3 Xtrackers MSCI World Swap UCITS ETF 1C
3.4 Comparison
4 Executive Summary and outlook
Research Objectives and Key Topics
This paper aims to provide a comprehensive analysis of exchange-traded funds (ETFs), specifically focusing on their structural characteristics, replication methods, and the impact of these factors on tracking performance. The central research question examines how different replication methodologies—physical versus synthetic—influence the efficiency and risk profile of ETFs tracking the MSCI World Index.
- Fundamental characteristics and benefits of ETFs as cost-efficient investment vehicles.
- Detailed evaluation of physical versus synthetic replication methods and associated risks.
- Technical analysis of the MSCI World Index composition and performance metrics.
- Comparative analysis of iShares and Xtrackers ETFs regarding tracking differences and fund structures.
- Factors impacting ETF performance, including security lending, taxation, and expense ratios.
Excerpt from the Book
2.2 Structures fund companies use to build ETFs
As described ETFs are securities which allow an investor to invest into a basket of securities, which are included in an index, with just one security. Thus at the end, the investor expects to receive the same performance as the index. While the goal of the fund company is to replicate the return of an index as efficient and accurate as possible, there are several ways for a fund company to replicate the index and thus achieve the performance of the underlying index. The structures to replicate an index can differ from fund company to fund company or from index to index and are described below.
Physical (full) replication:
An ETF with physical full replication tracks an index by directly buying all shares which are included in the index. Also the shares need to be weighted in the same way as in the index. The physical full replication is illustrated in the following picture:
As this method physically buys all the underlying shares of an index, it can be expected to be very precise. However this replication method reaches its limits if an index includes a very large number of shares (the MSCI World for example includes 1,563 companies) or if the index covers very illiquid markets, where it is not possible to buy and sell a large number of shares instantly. For these cases, other replication methods are used.
Summary of Chapters
1 Introduction: Provides an overview of the growing popularity of ETFs among retail investors and outlines the paper's focus on structural differences and performance metrics.
2 Structuring ETFs: Details the primary methods for constructing ETFs, including physical and synthetic replication, while analyzing key factors that influence tracking differences.
3 Comparison of two ETFs tracking the MSCI World Index: Evaluates two specific ETFs, comparing their replication strategies, portfolio composition, and historical tracking accuracy relative to the MSCI World benchmark.
4 Executive Summary and outlook: Synthesizes the main findings regarding the importance of understanding ETF structures and risk factors before investing, while providing an industry outlook.
Keywords
Exchange Traded Funds, ETFs, MSCI World Index, Physical Replication, Synthetic Replication, Tracking Difference, Total Expense Ratio, TER, Market Capitalization, Security Lending, Counterparty Risk, UCITS, Fund Domicile, Passive Management, Diversification.
Frequently Asked Questions
What is the fundamental focus of this research paper?
The paper examines the structural differences of exchange-traded funds (ETFs) and how these structures, specifically replication methods, impact the tracking performance of funds following the MSCI World Index.
What are the primary thematic areas covered in the text?
The core themes include the definition and benefits of ETFs, the mechanics of physical versus synthetic replication, the influence of fund domicile and cost structures, and the management of counterparty risk.
What is the main objective or research question of this study?
The objective is to compare how different replication methodologies and operational factors lead to deviations (tracking differences) between an ETF's performance and the underlying MSCI World Index.
Which scientific methods are employed throughout the document?
The author uses a comparative analytical approach, evaluating financial data, ETF fact sheets, and performance charts to determine the impact of replication strategies on fund efficiency.
What is discussed in the main part of the paper?
The main part explains the technical implementation of ETFs for portfolio diversification, categorizes replication techniques, and provides a comparative analysis of the iShares Core MSCI World and Xtrackers MSCI World Swap ETFs.
Which keywords are essential for understanding this work?
Key terms include physical and synthetic replication, tracking difference, total expense ratio (TER), counterparty risk, and index-based passive management.
Why does the research compare the iShares ETF specifically with the Xtrackers ETF?
These two are chosen because they track the same benchmark but utilize fundamentally different replication methods—physical sampling for iShares and synthetic swap-based replication for Xtrackers—allowing for a direct impact assessment.
How does the author explain the existence of counterparty risk in synthetic ETFs?
The author highlights that in synthetic funds, the index return is delivered via swap contracts, meaning if the swap counterparty becomes insolvent, the fund is exposed to a direct risk that does not exist in physically replicated funds holding the underlying assets.
- Citar trabajo
- Philipp Rothe (Autor), 2021, How do Exchange Traded Funds (ETFs) work? A comparison of two ETFs tracking the MSCI World Index, Múnich, GRIN Verlag, https://www.grin.com/document/1234776
