ETFs: What’s Better? Full Replication vs. Representative Sampling?

Passive investing has grown in popularity in recent decades relative to active investing. As it is argued, it is difficult, if not impossible, to outperform the market, which is supported by numerous academic papers that find the average mutual fund returns are equal to or lower than market returns. Passive investors, therefore, seek to match the market returns while minimizing the costs. These investors often skew towards exchange-traded funds (ETFs), which offer ownership in a large subset of the market by passively tracking the price movements of their underlying benchmark index. As a result, ETF returns are usually close to the market return, while their fees are typically low, especially relative to other, more active mutual funds.

ETFs employ two fundamentally distinct methods to replicate their underlying benchmark index. The more conventional method, physical replication, involves holding all constituent securities (full replication) or a representative sample (representative sampling) of the benchmark index. In contrast, the synthetic replication achieves the benchmark return by entering into a total return swap or another derivative contract with a counterparty, typically a large investment bank. As we have previously discussed, there is no significant difference in the tracking ability between the physical and synthetic ETFs in the long term. However, synthetic ETFs have more substantial tracking errors after a sudden increase in counterparty risk but are less affected by liquidity shocks than physically replicated ones. And while our article compares physical and synthetic ETFs, it does not address the differences between the full replication ETFs and sampling ETFs. Therefore, one may ask a question: “When selecting a physically replicated ETF, which replication method is better, full replication or representative sampling?”

A novel paper by Dyer and Guest (2022) offers several insights on this topic as it examines the tracking ability of 3,365 U.S.-based equity physical ETFs and mutual funds from 2010 through 2020. Among the studied funds, 52% use physical replication, 37% use representative sampling, and the remainder are “hybrids” that typically employ physical replication but may implement sampling under certain conditions. The study shows that sampling funds have higher turnover and expenses while earning worse returns relative to full replication funds. In particular, the differences in costs and returns translate into about 60 basis points lower returns for samplers per year on a net return basis. This finding is not driven by niche indices, as authors find similar results in the subsample of funds tracking the S&P 500 and other market-cap-based indices. However, differences between samplers and replicators disappear for funds following indices with many constituents (i.e., 1,000-3,000 stocks), suggesting that sampling can reduce replication costs in certain situations.

The replication vs. sampling dimension should be of interest to ETF investors, who are often encouraged to focus on factors such as expenses and fees when selecting investments. While these factors are certainly crucial, investors may have little awareness of the extent to which fund expenses and returns are driven by the mechanics, including replication vs. sampling, underlying their fund managers’ efforts to track a benchmark index.

Authors: Travis Dyer and Nicholas Guest

Title: A Tale of Two Index Funds: Full Replication vs. Representative Sampling

Link: https://ssrn.com/abstract=4057537

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