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Index funds have become extremely popular over the past decade as investors look to minimize cost. Rather than trying to beat a benchmark, index funds attempt to match the performance as closely as possible. The result is a lower expense ratio – since there’s less research required and fewer taxable capital gains – due to less frequent trading activity.
Let’s take a closer look at how indexing works and the four most common methods for accomplishing it.
Full replication involves purchasing all of the securities in a given index in the same proportion as the index itself. For example, an S&P 500 index fund would purchase the same stocks as the S&P 500 index in the exact same proportion in order to match the risk/return profile as closely as possible. Most index funds use full replication strategies for these reasons.
The strategy tends to mimic the actual index performance very closely since the only differences relate to how the portfolio manager uses cash flows and executes changes to the portfolio. However, the strategy may not be viable for indices with a large number of securities or funds that don’t have enough assets under management to efficiently deploy capital.
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Stratified sampling involves dividing an index into different buckets representing portfolio characteristics. Portfolio managers choose securities that will track these characteristics. In aggregate, the portfolio is representative of the underlying index without holding exactly the same components since the buckets contain highly correlated securities.
For example, a bond index fund may divide an index into different buckets representing issuer types, maturity dates and/or credit ratings. Two government bonds with the same maturity date and credit rating will have similar risk and return characteristics, which means that they could be used interchangeably as the government bond portion of a portfolio.
The strategy helps reduce transaction costs in indices with a large number of securities while making it feasible to invest in less-liquid asset classes. The downside is that the fund’s adherence to the benchmark index may vary depending on the bucket choices and execution strategy. Funds with more assets under management tend to more accurately track an index.
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Optimization takes stratified sampling a step further by looking at how all of the securities in an index interact with each other relative to the benchmark index. For instance, an emerging markets fund may look at externalities that aren’t necessarily reflected in obvious bucket choices, such as government interest rates or commodity prices.
As with stratified sampling, optimization reduces transaction costs in indices with large numbers of securities and makes it possible to invest in less-liquid asset classes. Optimization may still produce greater variance from a benchmark than full replication, but it may perform better than stratified sampling strategies when it comes to minimizing that variance.
Learn about other portfolio management concepts here.
Synthetic replication involves using derivatives to track a benchmark index rather than actually purchasing and owning the index’s components. For example, a fund tracking a precious metals index may use futures contracts or swap agreements in lieu of actually buying and selling gold or silver bullion due to the high storage costs involved.
This is a less popular strategy and is mostly used in markets where it’s impractical to hold the underlying assets. In addition to commodities, it may not be practical to buy and sell individual stocks in some frontier or in emerging markets that have high liquidity premiums. However, the cost to establish derivative positions often makes it inefficient in liquid and developed markets.
Many derivatives, such as swaps, require an upfront payment to establish the position, which generates an extra expense for the fund. These costs are partially offset by the fund’s ability to invest excess cash in short-term fixed-income securities, as well as its ability to avoid the transaction costs tied to buying and selling individual securities. The viability of synthetic replication depends on these variables.
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Index funds have become extremely popular over the past decade due to their low costs. Using the four indexing methods discussed in this article, funds can track nearly any type of index – from highly liquid stock indices to illiquid precious metals indices. Investors should be aware of the pros and cons of each indexing method before investing in an index fund.
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