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Portfolio managers have several ways for ensuring their index funds move in lockstep with the underlying market index they seek to replicate. The main strategies include the following:
1. Full replication
2. Stratified sampling and optimization
3. Synthetic replication
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This is useful for investors who want their index mutual funds to deliver the same return as the index they track. It’s mostly used to replicate the performance of large and liquid markets, such as the S&P 500 or Russell 3000.
A full replication strategy is advantageous only when you’re dealing with indexes that can be easily replicated. It provides broad exposure to the largest markets, ensuring better diversification and lower turnover costs. On the flip side, these advantages disappear when dealing with complex or illiquid markets, such as emerging markets. The leading example of a full replication index fund is the SPDR S&P 500 ETF (SPY).
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As the name implies, a stratified sampling strategy invests in a ‘sample’ of holdings from the underlying index. The combination of ‘sampling’ and ‘optimization’ means the portfolio gains exposure to certain segments of the index to provide an acceptable level of risk versus reward. For example. this could mean that you only invest in 75% of securities in the index. A prominent example is the Nationwide S&P 500 Index B (GRMBX), which invests at least 80% of its net assets in S&P 500 companies.
Sampling and optimization are beneficial because they provide the most representative sample of the index based on key metrics like exposure, risk, and correlation. But unlike the full replication strategy, sampling and optimization could leave you under-exposed to the index you are trying to track, which could lead to subpar returns.
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The advantage of this approach is that the fund doesn’t incur any purchasing or selling expenses. The downside is that the fee paid to the investment dealer is subtracted from the fund’s overall return. Additionally, synthetic portfolios are inefficient for developed liquid markets like the S&P 500 and are often used when dealing with emerging markets.
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