Indexing

Optimised indexing

Some index managers like Vanguard use optimisation techniques to build portfolios that mirror the index. Rather than holding all the securities in the index like fully replicated funds, the portfolio holds a representative sample. This is called partial replication.

Optimisation aims to reduce the higher costs of owning all the securities in the index while continuing to match the index return. Some indexes contain many illiquid stocks making it impractical and costly to own every stock in the index.

With partial replication, 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 optimized index portfolios, fund managers don't need to constantly buy and sell securities when index weightings change, resulting in lower turnover, costs and tax. For example, Vanguard's average turnover for its Australian equity funds is around 2 per cent to 5 per cent.

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. 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.