How do ETPs replicate an index?
There are three main ways an Exchange Traded Products (ETP) replicates an index. Other strategies may be used, investors should ensure they have read the prospectus and other relevant documentation prior to investing.
Fully replicated ETPs - These ETPs hold every investment, in proportion, within the index they are looking to track. For example, a fully replicated S&P 500 ETF would hold all 500 companies in the index.
Partially replicated ETPs - These ETPs do not hold every investment in the index, instead the manager chooses a portfolio designed to perform in line with the index, without holding every stock or bond. This process is called "optimisation" for shares and "sampling" for bonds.
Swap-based ETPs - These ETPs do not hold the assets within the index they are looking to track. Instead, the ETP will buy a swap (a type of derivative) usually from an investment bank who agrees to match the return of the index. They also hold collateral - stocks, bonds or cash unrelated to the index but of equal value to the ETP. This would be used to compensate the ETP if the swap provider were to run into financial difficulties.