There are a number of ways to track an index and the approach taken can vary significantly depending on the asset class, fund size, transaction costs and other factors. We consider three common tracking methods managers use and what it means for the portfolio that investors are investing in.
For equity index products, one of the more common approaches is full replication, which means holding every stock in the same percentage as it is represented in the index. When the index rebalances, so too will the fund – this ensures the accuracy of portfolio holdings, but can also limit flexibility. Some providers may look to incorporate an element of flexibility in the portfolio in order to reduce trading and minimise costs.
Full replication is perhaps the purest method of index-tracking and should produce a low tracking error. However, it can also be expensive since the transaction costs tend to be high for illiquid stocks and matching every index change, no matter how small, can incur unnecessary expenses which are ultimately paid by investors. Fund size is therefore crucial because larger funds are able to benefit from the economies of scale that minimise the impact of individual transactions and make this methodology viable.
An alternative to full replication is to hold only a representative sample of securities from the index. For example, a global bond index may contain many hundreds or thousands of securities, which depending on the size of the fund may be selected by dividing the index into sub-groups (say, maturity and credit rating bands) with representative securities taken from each.
The objective is to create a portfolio that mirrors the characteristics of each sub-group and, collectively, will also represent the whole market and thus, track the index.
Adopting a sampling technique can impact on tracking accuracy. The upside, however, is that this method can be cheaper to manage than full replication, thereby reducing the negative impact of transaction costs on tracking error. It is by no means exclusive to fixed income portfolios, for example a global equity index fund could hold a selection of shares from across each country and industry sector.
Rather than buying physical securities, funds can use derivatives to obtain synthetic exposure to an index. This is common in the Exchange Traded Product (ETP) market.
Synthetic ETPs generally involve holding a basket of securities, often with no reference to the index, and the return from this basket of stocks is translated into the index return via a derivative ‘swap’. This method is therefore more complex than other methods and raises a number of questions surrounding counterparty risk.
Synthetic ETFs can be a useful tool for gaining exposure to markets or asset classes that are difficult to access through a physical product, such as commodities, and the charges are generally low. However, those investing in them should fully understand how the products work, including being aware of the collateral and counterparty risk that they are taking.
The great attraction of index funds for investors is the ability to achieve something close to the market return at a low cost.
The best method for doing so will depend on several factors, including the asset class, liquidity and fund size, but whichever method is chosen it needs to be approached smartly in order to be as efficient as possible.