How Trackers Track

Published in Investing on 30 December 2009

Not all index trackers operate in the same fashion.

Index trackers, as most readers will know, track the performance of a given stock market index -- offering, in the process, a way of buying into a broadly diversified basket of shares at a low cost.

For over a decade, the Motley Fool has been promoting the idea of index trackers as a way for novice -- and not-so novice -- investors to benefit from the superior returns that the stock market has to offer, without the risks (and costs) of investing in individual shares.

And over that period, we've repeated some messages again and again. Go for trackers with a low cost, for example. Some passively managed trackers ("passively managed", because all they do is track an index) charge as much as actively managed investment funds -- which has to be ridiculous. Likewise, some trackers charge almost ten times the annual management fee and Total Expense Ratio (TER) of leading low-cost tracker providers such as Vanguard, HSBC, and Fidelity.

Another oft-repeated theme has been the importance of tracking error. Again, it's not difficult to understand. If the intention is to track the cost of an index, then the amount by which a given fund undershoots that performance due to costs not reflected in the official TER formula is still a cost to the investor -- even if the cost doesn't appear in the tracker provider's literature.

Under the hood

Here, I want to look at one of the less-frequently examined aspects of tracker performance: how the tracker actually achieves that tracking performance. It's an issue that has a bearing on both the 'hidden' and upfront aspects of index trackers' cost structure, tracking error and overall performance.

In a follow-on article next week, I'll show how real-life tracker managers apply these insights in practice to the tracker funds that they manage.

Full replication

The simplest way to track a given index is to simply buy the basket of shares that make up that index. Take the hundred or so shares in the FTSE 100, for example. ( I say "or so," because -- strangely enough -- the actual number may be one or two higher due to companies having different share classes.)

Simply buy the shares concerned, in the weightings that they take up within the index, and -- hey presto -- you've got an index tracker. In other words, as the stock market valuation of the FTSE 100 index rises and falls, so will the value of the basket of shares that you've just bought, to precisely the same extent.

"Our rule is that if we can fully replicate, we will," says Paul Lohrey, chief investment officer for Europe at tracker provider Vanguard. "Full replication delivers the purest and 'best' tracking -- but also has a number of disadvantages."

Such as? Well, in indices with a large number of shares -- such as the FTSE All-Share -- full replication will involve exposure to illiquid stocks with large 'spreads', for example. It will also entail the costs of buying and holding tiny amounts of some shares: at the lower end of the FTSE All Share index, for instance, some 300 or so stocks contribute just 3% of its market capitalisation. Both add to costs that are outside the TER calculation, and thus contribute to tracking error.

Stratified sampling

Hence the attraction of sampling -- not holding all the shares in a given index, but holding a specially-constructed sample of shares, designed to mimic the performance of the index while avoiding exposure to illiquid shares and uneconomic holdings.

Samples, of course, have something of a bad press. Despite that, investors shouldn't worry, stresses HSBC tracker manager Harvey Sidhu, who points out that fund managers supplement mathematical tools such as quadratic optimisation with proprietary portfolio analysis and optimisation tools such as MSCI's Barra Aegis and Northfield Information Services optimisation modelling software. The result: the best samples that money can deliver.

"We can impose constraints and criteria on the sampled portfolio so that it exactly matches given aspects of the underlying index -- such as its dividend yield, average market capitalisation, or sector split," he emphasises. "Throughout, the intention is to minimise the difference between the components of the index and the constituents of the sample."

Futures and derivatives

The third way of tracking an index is to use financial instruments such as index futures -- in effect buying an option on the index, rather than buying the underlying shares.

Some index tracker managers make use such means a lot more than others -- Fidelity appears to be a particularly heavy user, for instance -- but the basic advantage of futures is clear. Easily tradeable futures, in short, offer a way of managing cash flows in and out of an index tracker without being forced to buy and sell shares (perhaps in very small amounts) every time an investor buys or sell more units.

That said, holding futures in any volume involves something of a balancing calculation. For futures contracts don't pay dividends, points out Fidelity tracker manager Raheel Altaf, whereas the underlying shares of course do.

"Invest in futures, and you'll miss out on dividends -- but invest in the equities themselves, and you'll pay stamp duty," he notes. "It's a question of working out the right balance for what you want to achieve, over the period in question."

Putting it all together

So there we have it: three ways of building an index tracker. But which is best? Is there a 'one size fits all' solution? And should investors care? Answers to follow, next week.

More from Malcolm Wheatley:

Malcolm holds index trackers from Vanguard and HSBC.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

BarrenFluffit 30 Dec 2009 , 11:22am

interesting,

jerryrc 03 Jan 2010 , 12:27am

Thanks Malcom.

One question on use of futures contracts - do these then rely on counter parties to honour the contracts? And also, if the provider itself goes bust whilst holding those contracts then can investors' funds be at risk in that situation?

markwilkinson 04 Jan 2010 , 6:03pm

Interesting stuff; I'll be watching out for the next in the series.

One detail of Index funds that I've been unable to find any information on is how they handle things like rights issues. Would be interested if you could shed any light.

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