Physical versus Futures-Based Replication: The Case of Commodity ETFs

Abstract

This article examines various issues concerning the performance of commodity exchange-traded funds (ETFs) by taking into account whether these funds adopt a physical or a synthetic replication technique. The analysis first demonstrates that the physically backed ETFs perform better than their futures-based counterparts but they are riskier than them. Moreover, it is shown that the pricing of commodity ETFs, and especially the pricing of futures-based commodity ETFs, is somehow affected by developments in the equity market. The return of commodity ETFs is further affected by the implied and contemporaneous volatility of equity market as well as daily changes in the exchange rates of USD with such basic currencies as EUR and JPY. The tracking error of commodity ETFs is influenced by these market factors too. Finally, it is revealed that the tracking error of futures-based commodity ETFs is significantly higher than the tracking error of commodity ETFs that invest in the underlying commodities directly. This pattern applies both to bear and bull markets. In addition, the tracking error of the majority of commodity ETFs displays a mean-reverting behavior.