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Have you ever wondered what ETFs have to do with synthetic replication and what the abbreviations TER, TCO and TE stand for? Here’s a compilation of all the terms and expressions used in the industry to discuss ETFs and investments funds.
What is a Distributing or Accumulating ETF?
Index funds, including exchange-traded funds (ETFs), can be distributing or accumulating. As the name suggests, distributing ETFs and mutual funds distribute stock dividends, bond interest, and other income on a regular basis. On the other hand, accumulating ETF reinvests the dividend or interest back into the fund. Investors thus benefit from a kind of compound interest effect since the assets increase not only as a result of the amounts paid in and the price gains but also the income generated. Depending on your investment strategy, you should choose the type of ETF that best suits your goals.
What is a Replicating ETF?
All ETFs replicate an index. There are two ways to replicate the underlying index: physical replication and synthetic replication.
A physical ETF replicates an index by actually buying the stocks in the index – this is known as direct replication. If the ETF provider actually buys all of the securities in the index, then this is called full replication. Some issuers buy and sell only those stocks listed in the index that have a heavy influence on the index performance. This is called sampling or optimized sampling. However, this approach can more easily lead to discrepancies in price performance between the ETF and the index.
Synthetically replicating ETFs do not buy the securities included in the underlying index. Instead, they use financial engineering to replicate the return of a selected index. They replicate the index performance by using derivatives such as swaps. The swap transaction (also known as a swap agreement) is a derivative transaction conducted between the ETF provider and a swap counterparty.
The swap transaction works like this: Investor funds held in a synthetic ETF are invested in a basket of securities. This serves as collateral for the swap transaction. The securities in the collateral portfolio do not necessarily have to match the securities of the index being tracked. Thus, a synthetic ETF on the MSCI Europe can also contain American stocks in the collateral portfolio. The swap counterparty pays the ETF the index return, including all dividend payments. In exchange, it receives a ‘swap fee’ and the return of the securities in the collateral portfolio.
So, which one is better?
Synthetic replication is cheaper than physical buying and selling, but the risk is higher than with direct replication. If the swap counterparty becomes insolvent, investors may lose their entire deposits.
What is TER, TCO, TE, and TD?
The total expense ratio, or TER, makes it very easy to compare fees among funds. The TER provides an initial indication of the costs involved in investing in a particular fund or ETF. However, not all costs are reflected in the TER. The TER only indicates the annual ongoing costs of owning a fund.
The TCO, or total cost of ownership, is better. The TCO indicates the actual total cost of owning a fund and takes into account, for example, the swap fee for synthetically replicated ETFs, trading fees, and spreads for transactions within an ETF, as well as taxes and income.
To get a full picture of your investment expenses, you should also pay attention to the indirect fees generated by tracking error (TE). It measures the ETF’s deviation from the underlying index. If the TE is low, then the performance is very similar compared to the index. However, it is essential to note that the TE does not indicate whether the deviation is positive or negative; this is revealed by the Tracking Difference (TD). The TD indicates the difference between the return of the ETF and the return of the index that is tracked by the ETF.
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