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Key Message:

  • A fund manager may adopt one or a mixture of tracking strategies to achieve the index tracking objective. Investors need to know the differences among these strategies and their innate risks in order to determine if a particular ETF suits their needs.

To achieve the index tracking objective, a fund manager may adopt one or more of the following strategies:

  • full replication by investing in a portfolio of securities that replicates the composition of the underlying index;
  • representative sampling by investing in a portfolio of securities featuring a high correlation with the underlying index, but is not exactly the same as those in the index; or
  • synthetic replication through the use of financial derivative instruments to replicate the index performance.

The financial derivative instruments used in synthetic replication are mostly in the form of index-linked structured notes issued by a counterparty, or swaps, futures and options transacted with another counterparty. There are ETFs that use synthetic replication for index tracking purposes for efficiency and other cost reasons. Where an ETF tracks a market (or an index in a market) that has restricted access (eg, the China A-share market, Indian market), it can adopt synthetic replication through the use of financial derivative instruments.

As always, you should refer to their prospectuses to fully understand the features and risks of ETFs, including their replication strategies. To raise investors' awareness of ETFs that primarily adopt synthetic replication strategy (i.e. synthetic ETFs), the SFC worked with the Stock Exchange of Hong Kong (SEHK) and the fund industries to adopt measures aimed at helping investors to better differentiate different index tracking strategies of ETFs. More details about these measures can be found in the following articles: