Does the Replication Method Matter? Comparing Tracking Performance during Market Turmoil

Using a dataset of 2,290 European equity and fixed income ETFs spanning from 2001 to 2020, this paper examines the impact of replication methods on the tracking efficiencies of ETFs, particularly during market crises. The empirical evidence presented in this study challenges the notion that synthetic ETFs exhibit superior tracking performance when compared to physically-replicated counterparts. By identifying 119 indices simultaneously tracked by both physical and synthetic ETFs, we conduct event studies focused on significant market events including Lehman Brothers' bankruptcy, the sovereign debt crisis, and the COVID-19 outbreak. Our findings indicate that synthetic ETFs experience sharper declines in tracking efficiencies following sudden increases in counterparty risk while demonstrating greater resilience to liquidity shocks. Furthermore, we observe a noteworthy decline in the overall sensitivity of ETF tracking performance to market distress measures after the global financial crisis, with synthetic equity ETFs displaying the most pronounced effect.