Which statement about full replication in physical ETFs is correct?

• A. It uses a representative sample from each sector of the index.
• B. It involves counterparty swaps with a risk.
• C. It tracks the entire index, but is expensive, suitable for large portfolios.
• D. It does not track the index.

Answer: (C)

Full replication means the ETF manager holds every security in the index in the same proportions. This approach tracks the entire index with very low tracking error, because the fund mirrors each constituent rather than using substitutes. However, it requires buying and regularly rebalancing a large number of securities, which drives up trading and custody costs. These higher costs make full replication expensive, so it’s most practical for large portfolios where the fixed costs can be spread over a big asset base. Using a representative sample would be a sampling method, not full replication; swaps and counterparty risk describe a synthetic approach; and not tracking the index would contradict the whole point of full replication. Therefore, the statement that it tracks the entire index but is expensive and suitable for large portfolios is correct.