How to run an index fund

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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 liquid securities in well-known indexes like the S&P 500 or Russell 3000 to do exactly this.

But not all securities are as liquid as the stocks in the S&P 500, and some indexes include thousands of constituents, some of which barely trade. For ETFs tracking these more complex or less liquid corners of the market, full replication might not be the best – or most efficient – way to deliver the returns of the index.

Take an emerging market index with thousands of constituents, including small-cap companies in markets like Indonesia. Those Indonesian small-caps have miniscule weights in the index compared with emerging market giants like Samsung or Petrobras. As a result, adding them to a tracking portfolio is unlikely to move the needle on the fund’s performance.

Buying those small stocks will, however, add to the cost of building and maintaining the portfolio, because these securities can be costly to acquire. Managers must decide if the cost of acquiring a security overwhelms the tracking benefit of owning the security. Instead of adding a tiny position the fund manager might choose to simply add a small amount to an existing position in a more liquid, but very similar, highly correlated company. In this way, managers make important decisions in optimizing a portfolio.

While optimization happens in all kinds of index funds and ETFs, it is particularly common prevalent with Bonds. Many popular fixed-income ETFs track indexes that include thousands of bonds, often with little regard to their liquidity. Some indexes include bonds that haven’t traded since the day those bonds were issued, making it not just difficult but outright impossible to fully replicate the index. Here, optimization is the only option.

While optimization saves money, it does come with risks: The more aggressively a manager optimizes a portfolio, the more like it is that the returns will stray 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.

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Article copyright 2014 by ETF.com. Reprinted with permission from ETF.com. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

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