How are ETFs indexed?

Indexing techniques can vary depending on the number and liquidity of holdings in the target benchmark.

 

Equity ETFs

Equity ETFs use three primary strategies in an effort to track their benchmarks as closely and effectively as possible.

 

Full replication

The most common way to create an index portfolio is to fully replicate a target index by purchasing securities according to their relative weight in the index.

• Helps ensure tight tracking.
• Closely matches key characteristics of the index.
• Can result in higher transaction costs.

 

Sampling

The ETF holds a representative sample of the securities that make up the index. A sampling approach is used when there are liquidity issues or a large number of holdings in the index, making full replication difficult and costly. The sample aims to match the essential characteristics of the index and to track its returns.

• Divides securities into small groups across a variety of key characteristics.
• Allows a security to be chosen from that small group and weighted according to the corresponding weight in the index.
• Can result in increased tracking differential.

 

Optimization

Rather than using a sample based on industry or security characteristics, this approach uses a quantitative multifactor model in an effort to track the index.

• A computer model determines the optimal portfolio composition based on historical price changes and correlation of securities with the index.
• This strategy relies on historical data and factors that may change over time, which can result in greater tracking error.

 

Fixed income ETFs

For bond index ETFs, the sheer number of issues in their target indexes and the illiquid nature of many of these issues make full replication of the benchmarks impractical. Instead, most bond index ETFs seek to track their benchmarks through a sampling approach. Managers create samples that aim to match the essential characteristics of the bond indexes across such areas as:

• Average duration and average maturity
• Sector and subsector allocation
• Average credit quality
• Specific issuer risk controls