The impact of these on the fund’s performance depends on the strategy used to track the index.

Barclays favours full replication, whereby it holds all of the underlying constituents of an index, such as the FTSE 100, where possible. In contrast, both Lyxor and Deutsche Bank favour the use of index swaps, or synthetic replication. This method was first pioneered by Lyxor on its CAC 40 ETF, launched in 2001.

‘Deutsche Bank was a late entrant to the market and saw that the use of index swaps was a more efficient method of replicating an index. It effectively eliminates all sources of tracking error except the management fee, which is a known,’ says Mistry. ‘The index is a theoretical benchmark that does not take into account rebalancing costs or the taxation of dividends. But index swaps eliminate these real world factors and generate the index performance for the holder.’

Brown points out that the use of synthetic replication does, however, introduce counterparty risk into the ETF.

‘The risk may be small, if you consider Deutsche Bank is the counterparty for db x-trackers and Société Générale for Lyxor, but it introduces an additional layer of due diligence for investors. We would certainly be concerned if it involved banks of a lesser status because in many cases it is a risk that can be avoided,’ he says.

That said, full representation is not practical in illiquid markets or when tracking very large indexes, such as the MSCI World, which has over 1,800 constituents.

Issuers will typically use a sampling technique, holding a spread of stocks that act as a proxy for the market with an index swap overlay to reduce tracking error.