Index Tracking methodologies

when you hear about investments, bonds, and ‘tracking’ products that follow a certain index it is important to know exactly what is going on, today we will describe a technical difference between replication and sampled/optimised funds, and yes, we’ll keep it short so you don’t fall asleep!

Replication: This is where a fund literally replicates the asset under management, so they will match market value percentages of a bond in the fund to that of the percentage value of the bond in the index. Trading costs often prevent perfect replication and because indices can re-weight it may cause higher frequency trading for perfect replication.

Optimised/Sampling: In this approach an index is split into small individual cells, they are like a ‘sub-set’ index. Then the fund manager will either take a position that reflects similar risk/outlook of the subset or the smallest position required to give the overall weighting a certain sample weight. For instance, rather than having to take (for example) 1,000 bonds of Aviva they might take 500 but make sure that the overall fund is balanced in respect of the rest of the sample to index weights. This helps to produce a less risky portfolio by reducing the actual holding in assets that are open to liquidity risk/duration by industry/credit spreads etc.

So ‘sampling’ or ‘optimizing’ isn’t a bad thing, it merely means that the underlying asset tracking index ‘X’ isn’t done in a manner to replicate it exactly, if that was what you wanted you can often buy an index anyway, but it doesn’t always make sense to do so.

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