How To Run An Index Fund: Full Replication Vs. Optimization

The goal of most ETFs is to track the performance of an index. Fund managers have two ways they can do this:

  1. Full Replication: Buying all of the securities that make up the index
  2. Optimization: Buying the securities in an index that provide the most representative sample of the index based on correlations, exposure and risk

How Full Replication And Optimization Work

Investors want their index funds (or ETFs) to deliver exactly the return of the indexes they track. In a frictionless world, the way to do this would be obvious: Hold every security in the index, in exactly the same weight as the index.

This is called “full replication,” and it’s common for funds tracking large and liquid indexes like the S&P 500 or Russell 3000 to do exactly this.

But not all markets are as liquid as the companies in the S&P 500, and some indexes include thousands of constituents. For ETFs tracking indexes in more complex or less liquid corners of the market, full replication might not be the best way to deliver the returns of the index.

Think of an emerging market index with thousands of constituents, including small-cap companies in markets like Indonesia. These Indonesian small-caps won’t move the index much: They’ll have miniscule weights in the index, compared with emerging market giants like Samsung or Petrobras.

Despite their negligible impact on the index, these securities can still be costly to acquire. Optimizing managers must decide if the cost of acquiring the security overwhelms the tracking benefit of owning the security. Instead of nixing exposure altogether, optimizing managers might go so far as to identify a similar, less costly security that’s highly correlated to the original. In this way, managers make important decisions in optimizing an index.

If the reduction in expenses, as a percentage of the portfolio, is greater than the security’s impact on the index, the manager will deliver the returns of the index better than a full replication strategy would.

Fixed-income ETFs nearly all use a sampling approach, because oftentimes, the fund’s underlying index holds thousands of bonds, many of which haven’t traded in years.

While sampling saves on costs, it does come with risks: The more aggressively you optimize a portfolio, the more its returns could vary from the index over time, either on the upside or downside. Most ETFs track their indexes well, but there are dozens of examples of funds that have missed their benchmark by a few percentage points or more per year. Study a fund’s historical tracking to get a sense of how well the fund delivers the returns of its underlying index.

Next: Legal Structures, Regulation And Taxes

Other Articles Of Interest

Equity ETFs: An Intro To MLPs
Fixed Income ETFs: The Basics
Commodity ETFs: Why You Can’t Buy The Price Of Oil

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