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Questions -- How does one run an index fund? |
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At the simplest, an index fund is implemented by purchasing securities which make up the index. Most sensible indexes are market-capitalisation weighted, so the index fund also has to invest in the securities in the index in proportion to their market capitalisations. Such an index fund is said to utilise full replication. There is a common misconception that index funds have to trade every time prices change. This is not required, because the index fund weights change in exact synchrony with changes in market prices. Example: Suppose an index is made of two companies, which have prices $1 and $2, and are made up of 100 and 200 shares. Thus the market capitalisations are $100 and $400. Suppose an index invests in these to the extent of $1 and $4, i.e. buying 1 and 2 shares. Now suppose the prices change to $2 and $3. This makes the new market capitalisations to $200 and $600. The index fund which had a portfolio (1,2) now has values of $2 and $6, which is correctly on market capitalisation weights. This example illustrates that an index fund can simply sit tight when prices fluctuate. This portfolio will correctly track the changing weights of alternative stocks in the index. The index fund needs to trade when corporate actions (such as an SEO) take place, or when funds flow in/out of the fund. |
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At the simplest, we have plain vanilla index funds, which only invest in securities using the weights specified in the index. These funds will, in general, underperform the index since the index fund suffers transactions costs and management fees. Alternatively, we can have index plus funds, which utilise stocklending and index arbitrage to add positive errors to the index fund performance. This may increase tracking error, but generally improves the information ratio. Finally, we can have synthetic index funds, which utilise index futures and index options in implementing the index fund - they don't actually own any shares. These terms are not universally agreed upon. The above is an attempt at reflecting a broad consensus on terminology. However, there are shades of gray and certain difficulties with terminology. Sometimes, a fund which is apparently under [active management]? may actually be substantially invested in an index. This is called closet indexation. Sometimes, the fund manager is under a contractual obligation that while he can do active management, his tracking error will not exceed a stated level. This fund manager seeks opportunities to outperform the index while basically staying close to index performance. Sometimes the term index plus fund is used to describe such a policy also. |
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