There are 3 main types of index fund structures (refer to What is An Index Fund?). Which are as follows:-
- Managed Funds
- ETFs (listed managed funds)
- Listed Investment Companies (not technically index funds but included for the sake of completeness)
Within each type of structure there are are many, many ways to replicate the index, but all the methods tend to fall within the three categories below:-
Full replication – invests in all securities in an index
Partial replication – holds a representative sample of securities in an index
Synthetic replication – invests in derivative products such as swaps and futures that follow the performance of the index
The methods are not mutually exclusive, a fund might for example choose to hold 75% of the index using the full replication method and 25% using synthetic replication. The end always justifies the means in index replication!
ETF Full Replication
The ETF or index fund simply buys every stock in the index (also refer to How Index Funds Work). The funds performance should match the performance of the index (referred to as a low tracking error) less costs such as management fees, transaction costs and stamp duty.
ETF Partial Replication
The ETF or index fund holds a representative sample of the index being tracked, quantitative computer models are often employed and the tracking error is often quite small. For example a fund tracking the MSCI world index might only hold 60-75% of the stocks in the underlying index. The remaining stocks may be illiquid, there could be restrictions on the foreign ownership of stocks or tax constraints etc
ETF Synthetic Replication
Essentially an index fund or ETF enters into a swap agreement with an investment bank, who promises to deliver the index performance in return for a fee. Essentially the responsibility for tracking the index is transferred from the index fund to the investment bank. The advantage of swaps is they are not subject to stamp duty and other transaction costs, the disadvantage is counterparty risk (eg the risk the investment bank reneges on its agreement).