Types of tracking
- 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.