We look under the lid of the cheapest index trackers on the market.
Last week, I looked at how index trackers actually perform their wonderful wealth-building magic. Talking to index tracker managers at several of the major low-cost index tracker providers, I explained how managers had a variety of tracking options to choose from.
Full replication, for instance, involves -- as the name implies -- simply buying all the underlying shares. The logic: if the index goes up 5%, then a basket containing all the shares that make up that index should also go up by 5%.
Structured sampling is another option. Holding small numbers of illiquid shares with high spreads isn't economic, and also adds to tracker managers' costs -- and therefore the return that they can pass on to investors. The solution: don't hold all the shares in the index (the FTSE All Share contains over 600, for example), but instead hold a carefully designed sample, structured so as to precisely mimic the index.
Finally, I looked at futures and derivatives. Instead of buying and holding shares -- which involves paying custody costs and stamp duty, instead hold financial instruments such as futures contracts. The index goes up by 5% -- and so does the value of the futures contract.
Why does it matter?
While investors shouldn't obsess over precisely which method managers use, it is worth being aware of the general advantages and disadvantages of the respective methods.
Sampling, for example, is cheaper than full replication -- but runs the obvious risk that the sample is flawed, or misses out on a share which soars to stellar heights. AIM is stuffed with miners and oil explorers: if one becomes an overnight 1960s-style Poseidon, with a share price that suddenly goes stratospheric, there will be an effect on the index.
Futures contracts, too, should be as safe as houses. But as we saw with the collapse of Lehman Brothers, there is a counterparty to every contract -- and if your counterparty collapses, will the contract be honoured? More troublingly, there's "basis risk" -- where futures contracts price in the expected level of dividends, not the actual level of eventual payouts, and so track the underlying index only imperfectly.
Which leaves full replication. It isn't cost-free, and may well cost more than a sample. But it will -- by definition -- track the index. And at the end of the day, that's why many of us buy index trackers.
Research that I've alluded to before from low-cost tracker provider HSBC (LSE: HSBA), for instance, makes it clear that knowledgeable investors understand these points.
"If given a preference, investors prefer tracking funds that use full physical replication rather than the use of samples and derivatives," says David Chellew, head of marketing at HSBC Global Asset Management.
Accordingly, no fewer than three of HSBC's trackers use full physical replication: its FTSE 100, FTSE 250, and S&P 500 trackers. And HSBC's European tracker is 90% replicated -- the principal reason being, he explains, the existence of European companies such as Volkswagen and Italy's Telefonica which have dual listings.
"It's all down to cost management: it's expensive," he notes. "For every stock, there's a custodial charge, and in the interests of keeping charges low, we seek to avoid those charges."
Vanguard and Fidelity, too, use full replication where they can. Vanguard's Developed World ex UK and FTSE Equity Income trackers use full replication, for instance, explains Paul Lohrey, chief investment officer for Europe at Vanguard. Fidelity, for its part, uses full replication for its FTSE 100, FTSE 250 and Euro Stoxx 50 trackers, adds Fidelity tracker manager Raheel Altaf.
Sampling versus futures
Where the major tracker managers differ more in their approach is when they can't economically use replication -- such as in the FTSE All Share, where 300 different stocks make up just 2% of the index.
HSBC prefers sampling to futures contracts. The FTSE 100 and 250 constituents are fully held, with much of the remainder sampled. Futures are limited to just 5% of their potential maximum representation, far less than regulations permit, and largely because of a desire to avoid basis risk. "We are conservative," says HSBC tracker manager Harvey Sidhu. "But we prefer to avoid basis risk."
Vanguard, too, is cautious. "Our rule is that if we can fully replicate, we will," says Lohrey. "Otherwise, it's sampling. For our UK funds, we use futures modestly and judiciously -- largely because of basis risk."
Fidelity is more sanguine. Noting that 97% of the shares in its FTSE All Share MoneyBuilder UK tracker are fully replicated via FTSE 100 and FTSE 250 holdings, Fidelity's Raheel Altaf explains that futures can comprise as much as 30% of the remaining index exposure.
The strategy, he explains, is to use futures to absorb daily cash in-flows, with conversion to the underlying equities being grouped in order to minimise cost.
"If I converted the 30% in one go, there would be a material impact on cost, which would add to the tracking error," he points out.
So there we have it. Cautious HSBC and Vanguard on the one hand -- and Fidelity on the other, exploiting futures to effectively reduce tracking error. As the saying has it, you pays your money, and you takes your choice.
Which approach do you prefer? Comments in the box below, please!
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Malcolm owns FTSE All Share and FTSE 250 index trackers from HSBC, and FTSE All Share and FTSE Developed World ex UK trackers from Vanguard.