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Key Message:

  • A passive ETF 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 passive ETF suits their needs.

To achieve the index tracking objective, a passive ETF 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.