How are ETFs indexed?

 

Equity ETFs

There are three primary strategies that equity index ETFs employ in an effort to track their benchmarks as closely and effectively as possible.

Full replication

The most common means of creating an index portfolio is to fully replicate a target index by purchasing securities in the index according to their relative weight in the index.

  • Ensures tight tracking.
  • Closely matches key characteristics of the index.
  • Can result in higher transaction costs.

Sampling

The ETF holds a representative sample of the securities that make up the index. An index-sampling approach is used when there are liquidity issues or a large number of holdings in the index, making full replication very difficult and costly. In the aggregate, the sample aims to match the fundamental characteristics of the index and to track its returns.

  • Divides securities into small groups across a variety of key characteristics.
  • Allows a security to be chosen from that small group and weighted according to the corresponding weight in the index.
  • Can result in increased tracking differential.

Optimization

Rather than using a sample based on industry or security characteristics, this approach uses a quantitative multifactor model in an effort to track the exposure in the index.

  • Historical data on price changes and correlation of securities are input into a computer model to determine the optimal portfolio composition.
  • This strategy relies on historical data and factors that may change over time, which can result in greater tracking differential.

 

Bond ETFs

For bond index ETFs, the sheer number of issues in their target indexes and the illiquid nature of many of these issues make full replication of the benchmarks prohibitive. Instead, most bond index ETFs replicate their benchmarks through a sampling approach.

Managers create samples that aim to match the fundamental characteristics of the bond indexes across such areas as:

  • Average duration and average maturity.
  • Sector and subsector allocation.
  • Average credit quality.
  • Specific issuer risk controls.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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