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In several posts of the Investing Guide for Beginners, we have focused on index funds. But do you know how index funds are replicating the performance of the index? It is what we are going to discuss now.
Index funds are replicating an existing stock market index. For instance, many mutual funds and many ETFs are replicating the S&P500 index. In this post, we are going to focus on index replication.
There are several different ways of replicating an index. There is physical index replication and synthetic index replication. It is essential to know how funds are replicating the index. You should know the different ways they are using for replicating the index. It will help you make the right choice of ETF.
Let’s take the Standard & Poor’s 500 (S&P 500) index, for example, again. It is composed of 500 US companies that have the largest capitalization in the stock market. Now, let’s suppose you want to have a fund that replicates this index. The index is market-capitalization weights. It means that Apple has more shares than Pepsi. If one company has 20 times more capitalization than another one in the index, it should also have 20 times more value in the fund.
The fund should replicate the index as close as possible. If one company is 1.234% of the index, it should be 1.234% of the fund. But this is very difficult to do. The smaller the fund is, the more difficult it is to replicate the index correctly. A serious difficulty is that some stocks are costly.
Let’s imagine that one stock is worth 100’000 USD. If that stock represents 1% of the index, you need at least 10 million to replicate the index. That means a fund with less than 10 million cannot replicate the stock market index entirely. And that also means that a fund with 11 million USD cannot replicate the index correctly.
It is almost impossible, or highly impractical, to perfectly replicate the index.
If the fund is large, like Vanguard S&P 500, the differences between the index and the fund are almost negligible. That is an excellent reason to choose larger funds over small funds, especially for ETFs.
But for small funds, you will often see a difference in the number of companies held truly as shares. For instance, if you take an index such as the Russell 3000 index with 3000 companies, many funds following this index will have less than 2000 companies. This is because the smallest companies will have a very low percentage of the overall value. So, unless the fund is huge, they will not go all the way into each company.
Regardless of the size of the index and the fund, there are two main strategies to replicate an index. We will see them both in detail now.
Physical Index Replication
The first strategy is to hold the real stocks.
It is physical index replication because the fund will hold the shares of all the companies in the index. This is a strategy that makes a lot of sense because it is natural. This is what people would do if they wanted to replicate the performance of an index.
The bigger the fund, the more shares they will have of each company. They need to replicate as close as possible each company’s weight in the index. Once they need to buy shares, they will buy more shares of the large companies than small ones.
If a fund owns shares of all the companies in an index, it is called Full Replication. Sometimes, it may not be easy (or convenient) to own shares of each stock in the index. It is valid for very large indices. And this is true for small index funds that do not have a large asset value.
Therefore, some funds use another strategy, Sampling. They only own shares of some of the companies in the index. They are also trying to replicate the index correctly. What is more complicated with a Sampling fund is that it can also hold other financial instruments. For instance, some sampling funds are investing in futures and options to help replicate the index.
It is up to you to decide which strategy you prefer. I think Full Replication is superior to sampling. It will more accurately reflect the index, in my opinion. But you should be aware of both flavors before investing.
Synthetic Index Replication
The second strategy is to hold derivatives.
It is called synthetic replication because it uses derivatives and not directly using the stocks of the companies. These kinds of funds are generally using swaps, a form of derivatives. Swaps are contracts, usually with a financial institution, for the returns of the index. If the index gained 1%, the counterparty pays 1%. It is a kind of loan with an interest rate based on the index returns.
There is more risk with this kind of replication. The problem is because of the counterparties. This means you are relying on them to get your returns back.
If one of the counterparties cannot honor its returns, the returns of the fund will be lower than the index. And if the counterparty defaults, the fund can lose money.
Generally, funds are trying to avoid this. One fund will have many contracts with different counterparts. And they will also use collateral. So if the counterpart does not honor its returns or defaults, the fund has a claim to the collateral. Nevertheless, this is a risk. And this makes this form of replication much more complicated than simply holding the stocks.
On the other hand, there are two advantages to this kind of fund.
First, such funds are generally able to replicate the index very precisely. Indeed, even small funds can be very close to the index. On the other physical replication is not good for small funds.
And these funds can have very low costs since they do not have transaction costs. The only cost is normally only the costs of the contract costs. But these costs are generally not occurring very often.
For me, there are too many things going on for this kind of replication. But there are advantages. And you should know what synthetic funds are if you want to invest in index funds. I prefer physical replication for index funds.
In general, you should prefer physical replication for all your funds. Most large indexes have several funds physically replicating them. Only when you try to invest in some special indexes will you find many synthetic ETFs.
Now you know how a fund is replicating the performance of an index.
There are two main strategies for index replication. Either the fund holds the shares (Physical Replication) or derivatives such as swaps (Synthetic Replication).
I much prefer Physical Replication. It is the technique that is the easiest to understand and to follow. If you only invest in broad indexes with a large value, you should easily find funds with Physical Replication for this index. Most good funds for large indexes are physically replicated. All of the funds in my portfolio are using physical replication.
It is important to know the different index replication strategies. Once you know what the different options are, you can choose the one you prefer. And you can choose within a vast choice of ETFs and mutual funds. I prefer physical replication and especially full replication. But that is up to you!
If you want to learn even more about ETFs, you can read about how ETFs stay synchronized with the price of their index.
What do you think about these index replication techniques?