While there are over 1,800 ETFs available in Europe, most of their assets are invested in traditional index-based ETFs. Indexing is a passive investment strategy that attempts to track the returns of a specific market index as closely as possible by holding all, or a representative selection of securities in the index. Most ETFs aim to track market-cap-weighted indices and are available in an increasing number of styles and asset classes, including regional and global equity and fixed income markets.
They range from products that invest in the widest coverage of the markets to those that invest in specific industries. Some style ETFs cover the growth and value spectrum, and others track certain market-capitalisation 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.
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 indices should be constructed according to the market capitalisation of the underlying constituents. Weighting securities according to their market capitalisation is the most commonly used method. Market-cap-weighted indices 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 capitalisation. Let's look at how index ETFs track their benchmarks. These ETFs use three primary strategies to track their benchmarks as closely and effectively as possible. These are full replication, sampling and optimisation.
Let's start with 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 indices with liquid constituents such as the S&P 500, Euro STOXX 50 or government bond indices.
Next is 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. The sampling strategy divides securities into small groups across a variety of key characteristics. It allows a security to be chosen by the portfolio manager from that small group and weighted according to the corresponding weight in the index. And it 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 indices and the less liquid nature of some of the issues. And finally, optimisation. Rather than using a sample based on industry or security characteristics, this approach uses a quantitative multifactor model to track the index.
The optimisation strategy uses a computer model to determine the optimal portfolio composition based on historical price changes and correlation of securities within the index. And it 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 indices with lots of constituents such as the FTSE All-World Index, replicate their benchmarks through optimisation.
