Many investors prefer their exchange-traded funds (ETFs) to try to match the performance of an index. This can be accomplished by investing in index funds, which typically purchase a basket of stocks designed to mimic one of the major indexes, such as the S&P 500. Investors who choose to invest in the stock market through index funds can do so through one of two main strategies: full replication ETFs or sampling ETFs. Below, ETFdb.com discusses the key differences between sampling and replication.
Full Replication ETFs Explained
The first method when investing in ETFs is known as full replication. This is when an investor simply buys an ETF that holds all of the same securities as the index they wish to track. Since the ETF holds every security with the same weightings, an investor can create a nearly identical replica of the underlying index.
There are index funds that allow full replication of market indexes. For example, the SPDR S&P 500 ETF (SPY ) tracks the performance of the S&P 500 Index. It is very closely matched to the S&P 500, with an average price-earnings ratio of 17 and a 2.2% dividend yield. It achieves the objective of full replication by holding a portfolio of all the stocks in the S&P 500 Index with similar weightings that correspond to the index weightings. Similarly, the SPDR Dow Jones Industrial Average ETF (DIA ) holds a portfolio of the 30 common stocks that are included in the Dow Jones Average.
Sampling Strategy ETFs
In comparison to the full replication strategy, there is also the sampling strategy. This strategy is used when buying every security in an index is impossible, or inefficient. Sampling strategy refers to a “sample” of holdings from the underlying index. For example, if only 80% of the securities from an underlying index are included in an ETF’s holdings, then the fund is sampling from rather than fully replicating the index. Sometimes an equity index to which an investor wants exposure might be too complex or may have too many holdings. In these cases, the ETF that tracks the index may use a sampling strategy. Instead of avoiding that index or market altogether, an ETF can use a sampling strategy to gain exposure and optimize the exposure to the index.
There are also ETFs that track the performance of the Russell 2000, which is the index comprising small-cap U.S. equities. But since it is not efficient to hold every individual stock in the entire index, many index funds use a sampling strategy to replicate the index. One example is the iShares Russell 2000 ETF (IWM ). IWM invests 90% of its assets in stocks from the underlying index. Its remaining assets are invested in products such as futures, options and swap contracts, as well as securities not included in the underlying index. This is done because the fund manager feels these instruments will create a more efficient replica of the original than trying to purchase every stock in the index. Rather than buying all 2,000 stocks that compose the Russell, and then have to exactly match the weightings of each security, the fund manager uses approximately 10% of assets to replicate the index with derivatives.
The Bottom Line
For most investors who want to index, full replication is the better way to go when it comes to indexes that can be easily replicated, such as the Dow Jones Industrial Average or the S&P 500 Index. But sometimes, the sampling strategy is better. When constructing ETF portfolios, investors must decide whether they prefer a full replication strategy or are content with a sampling strategy. It must be acknowledged that in certain cases, buying every security in an index is not possible. That is why investors should familiarize themselves with each strategy before investing.