There are two key approaches to managing index portfolios, full replication and optimisation.

Full replication

Full replication portfolios hold every stock in the index in proportion to the total stock market capitalisation. The price and market capitalisation of individual companies in the index varies constantly. With fully replicated portfolios, each time the index changes the manager updates their holdings, through buying and selling stocks, to maintain the index weights. This approach is feasible where an index comprises mainly large highly liquid stocks, for example, the S&P/ASX 50 (the largest 50 stocks in the Australian stock market).

Full replication can be costly because trading stocks incurs transactions costs - brokerage, stamp duty, market impact etc. As the number of stocks increases, tracking error falls but costs rise. Tracking error measures how closely a portfolio follows its benchmark and is measured using the standard deviation of differences in return between the portfolio and the index.

Optimisation

An alternative to holding all stocks in an index is to use optimisation where the portfolio owns a broad representative sample of the index. This approach involves trading-off the reduced costs of partial replication against the risk of not matching the index return.

For broader indexes containing many illiquid stocks, it is often impractical and unnecessarily costly to try to own every stock in the index. So for broad indexes such as the S&P/ASX 300 Index, or the MSCI World ex-Australia Index, it is generally preferable to own a broad representative sample of the index. This way the portfolio still tracks the index closely, but the costs of trading in many illiquid stocks in the small, "tail-end" of the index are reduced. The fund still holds small capitalisation stocks but rather than holding every stock in the index, a representative sample is held.

With optimised index portfolios, changes in index weightings are reflected in the index fund but it doesn't result in any buying and selling of securities. This is because the value of the stock in the fund will rise and fall with the stock in the index. The result is that an index manager does not need to adjust the portfolio on the basis that the weighting of a stock has changed. Trading only becomes necessary when the index constituents actually change, or where buying and selling is necessary to meet applications and withdrawals.

Optimisation takes a large number of factors into account, including the financial characteristics of securities in the index and the correlation in behaviour between stocks. In this way, the index manager builds a portfolio that is "optimal", reducing the tracking error of the portfolio relative to the index while at the same time keeping transaction costs low.