(Disclosure: Some of the links below may be affiliate links. For more information, read my disclosure.)
In the previous post of the Investing Guide for Beginners, we talked about Exchange Traded Funds (ETFs). Before that, we talked about mutual funds. In both these two cases, we focused, especially on passive index funds. Index funds are replicating an existing stock market index. For instance, the SP&500 index is replicated by many mutual funds and many ETFs. 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 important to know how funds are replicating the index. If you want to make a good choice between the different ETFs and mutual funds that exist, it is important to know the different ways they are using for replicating the index.
Let’s take the Standard & Poor’s 500 (S&P 500) index for example again. It is composed of the 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 have also 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 correctly the index. A big difficulty is that some stocks are very expensive. Let’s imagine that one stock is worth 100’000. 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 market. And that also means that a fund with 11 million cannot replicate the index perfectly.
It is almost impossible, or highly impractical, to perfectly replicate the index. In general, if the fund is large, like Vanguard S&P 500, the differences between the index and the fund are almost negligible. That is a good reason to choose large funds over small funds. Especially for ETFs.
Physical Index Replication
The first strategy is to hold the real stocks. This is called physical index replication because the fund will hold the shares of all the companies in the 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 bigger companies than the small.
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. This is true for very large indices. And this is true for small index funds that do not have a large assets value. Therefore, some funds use another strategy that is call Sampling. They only own shares of some of the companies in the index. They are also trying to replicate correctly the index. 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. This 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. This is called synthetic because it is using 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, generally with a financial institution, for the returns of the index. If the index gained 1%, the counterparty pays the 1%. It is a kind of loan with an interest based on the index returns.
There is more risk with this kind of replication. If the counterpart is not able to 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, this is avoided by two things. One fund will have many contracts with different counterparts. And they will use a collateral. So if the counterpart does not honor its returns or defaults, the fund has a claim to the collateral.
On the other hand, there are two advantages to this kind of fund. They are generally able to replicate the index very precisely. Even small funds can be very close to the index. And they can have very low costs since they do not have transaction costs. Only contract costs, but they are generally not occurring very often.
Personally, I think it is a bit 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 really prefer physical replication for index funds.
Now you know how a fund is replicating the performance of an index. There are two main strategies for index replication. Either the fund really holds the shares (Physical Replication) or it holds derivatives such as swaps (Synthetic Replication). Personally, I much prefer Physical Replication. This 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.
I believe it is important to know the different ways there is of replicating an index. Once you know exactly what are the different options, you can choose the one you prefer. And you can actually make a choice in a very large offer or ETFs and mutual funds. Personally, 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?