Index ETFs aim to track the returns of a specific market index by holding all or a representative selection of securities in the index.
Most ETFs aim to track market-cap-weighted indexes and are available in an increasing number of styles and asset classes, including regional and global equity and fixed income. They range from products that invest in the widest coverage of the markets, to those that invest in specific industries.
Some ETFs cover the growth and value style spectrum, and others track certain market-capitalization ranges. International ETFs cover the global markets and may offer exposure to a single country or region of the world. Finally, fixed income ETFs can cover a variety of duration, credit quality and maturity ranges.
Market capitalization: The traditional weighting methodology
An index is a group of securities chosen to represent an unbiased view of the risk-reward attributes of a market or portion of a market. Vanguard believes that indexes should be constructed according to the market capitalization of the underlying constituents.
Most ETFs weight their underlying securities according to their market capitalization. Market-cap-weighted indexes reflect the consensus estimate of each company's value at any given moment. In any open market, new information—economic, financial or company-specific—affects the price of one or more securities and is reflected instantaneously in the index via the change in its market capitalization.
How index ETFs track their benchmarks target index with an ETF
Index 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. This process helps ensure an ETF tightly tracks its index while closely matching key index characteristics. Full replication is typically used for concentrated indexes with liquid constituents such as the S&P 500 Index, S&P/TSX Index or government bond indexes.
Sampling
The ETF holds a representative sample of the securities that make up the index. A sampling approach is used when there is 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.
This strategy:
- Divides securities into small groups across a variety of key characteristics.
- Allows a security to be chosen by the portfolio manager from that small group and weighted according to the corresponding weight in the index.
- Can result in increased tracking differential.
Most bond index ETFs replicate their benchmarks through a sampling approach. Full replication for bond ETFs is often impractical due to the sheer number of issues in their target indexes and the less liquid nature of some of the issues.
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.
This strategy:
Uses a computer model to determine the optimal portfolio composition based on historical price changes and correlation of securities within the index.
Relies on historical data and factors that may change over time, which may result in greater tracking error, albeit at a generally lower cost.
Most equity ETFs tracking indexes with lots of constituents, such as the FTSE All-World Index, replicate their benchmarks through optimization.