The quick thumbnail description of asset managers is that on the one hand you have the star portfolio managers who pick the right stocks at the right time—and on the other hand you have index managers whose jobs are easy because they are following indexes and generally investing on autopilot. That impression couldn’t be more wrong.
Investing is never passive. Tracking an index requires marksman-like skill, and index managers are tasked with hitting the bull’s-eye every day.
Two Types Of Index Tracking
Passive managers work in one of two ways: either they try to fully replicate an index or they hope to optimize their results by removing those parts of the index that weigh down performance.
In the first approach, an ETF holds all of the securities that make up its underlying index and mimics their respective weights. Optimization, on the other hand, uses constraints to minimize tracking error and obtain the risk and return characteristics of the whole index without owning the costly tail portion—usually the smallest, most expensive securities.
Knowing where and when to employ full replication versus optimization requires an evaluation of tracking and transaction costs. For highly liquid indices like the S&P 500 that don’t have an overly broad set of holdings, full index replication likely will be the most efficient way to manage a portfolio. But when tracking much broader indexes, especially those with many less liquid small-cap or emerging-market stocks that rack up higher trading costs, optimization strategies are a better route.
A fund’s asset size is another important factor. It is generally more difficult to fully replicate an index if there are fewer assets under management. The higher the AUM, the more names an ETF will typically hold. However, just because an ETF has a lot of assets doesn’t mean it will use full index replication.
Let’s take the MSCI ACWI IMI Index as an extreme example. Because it has more than 8,500 constituents, it really doesn’t matter how big the portfolio is. There are too many small, expensive names at the bottom capitalization of this index for it to be fully replicated. This trade-off between tracking and owning the very expensive (in other words, more infrequently traded) tail of this index means an MSCI ACWI IMI portfolio will likely have to be optimized to capture its true risk and return characteristics without owning all 8,500-plus securities.
The Optimization Process
Asset managers who choose the optimization route on their equity portfolios must put in the proper constraints on the sectors, market caps, countries, currencies and factor exposure. They can also use models that penalize those holdings that are costlier while favoring more liquid stocks that are easier to trade.