ETFs which use direct replication buy the securities of the underlying index being tracked. Some direct replication ETFs buy all the underlying securities in the index, otherwise known as 'full direct replication'. Others will only buy a subset of the securities that constitute the underlying index being tracked. This is referred to as sampling, and tends to be used for ETFs tracking very broad indices, or indices which may contain illiquid underlying securities.
Direct replication can work well – meaning the difference between the performance of the ETF and the underlying index it is designed to track should be low – for funds tracking developed market indices, where underlying securities can be easily bought and sold and where transaction costs can easily be absorbed by the fund
ETFs which use direct replication often engage in securities lending, which involves the fund lending out its assets in return for fees, with the profits being used either partly or wholly to improve the performance of the fund.
The new direct replication ETFs being launched by db X-trackers to give investors replication choice will all use full, direct physical replication. It is envisioned that they will also engage in securities lending.