Liquidity risk, return performance, and tracking error: Synthetic vs. Physical ETFs

As the global ETF market continues to grow, the significance of understanding replication strategies has become increasingly apparent. This study examines the compensation of synthetic exchange-traded funds (ETFs) due to their greater risk exposure than physical ETFs, using ETFs listed on developed European markets from 2009 to 2020. This is the first study to investigate liquidity risk related to the replication strategy of ETFs. We investigate the difference in systematic liquidity risk between synthetic and physical ETFs using a liquidity-adjusted capital asset pricing model (LCAPM). Our findings suggest that synthetic ETFs have higher liquidity risks than physical ETFs and offer additional returns within the low-liquidity group. We also analyze the tracking performance of ETFs based on their type and find that the synthetic replication method reduces tracking errors within the high-liquidity group. Specifically, the enhanced tracking performance of synthetic ETFs becomes more prominent during periods of liquidity shocks than in regular periods. These findings shed light on key considerations for resolving puzzles in tracking errors.