Index-EtfMedium

4 min read · 654 words

What the seat actually does

An index seat has no view and one obligation: hold what the index holds, so that the fund's return differs from it as little as possible. There is no credit for a good year and no forgiveness for a gap.

The difficulty is that the index is free and the fund is not. An index rebalances at a closing price with no commission, no tax and no spread. A fund has to actually buy the shares, at a price it moves by buying them, and pay for the privilege. Every basis point of that difference has to be found somewhere.

• Replication — full, where every constituent is held; or sampled, where a subset is chosen to behave like the whole; or synthetic, where a swap delivers the return and somebody else holds the assets.
• Rebalance — the index changes on an announced date, and so must the fund, alongside everybody else doing the same trade.
• Income — dividends, and lending the shares out, which is where much of the tracking gap is closed.
• Creation and redemption, on an ETF: the mechanism that keeps the traded price near the value of what is inside.

A day, and where it goes

• Cash to invest — subscriptions arrive and are uninvested until they are not, and uninvested cash is tracking error.
• Corporate actions — a merger, a split, a rights issue in one constituent, each of which the index treats by a published rule the fund has to match exactly. See corporate actions.
• Rebalance preparation — the announced changes, and how to trade them without being the flow everybody else is trading against.
• The gap — measured daily against the index, and explained when it is not what was expected.

What it is measured on

• Tracking difference — how far the fund's return sat from the index over a period. It is usually negative by roughly the fee, and a fund that beats its index has taken a risk somewhere.
• Tracking error — how variable that gap is. The two are different numbers and confusing them is the standard mistake.
• On an ETF, the premium or discount to net asset value, and the spread the market maker shows. See ETFs.
• Cost of the whole thing, since that is what the product competes on and almost nothing else.

What it touches on this site

• The instruments — ETFs, mutual funds and the total return swaps behind the synthetic ones.
• Who is forced to trade — every asset class page answers "who is choosing, and who is forced", and an index fund at a rebalance is the purest example of forced.
• Where the income comes from — securities lending.
• What the wrapper changes — the same exposure in different containers.

How it goes wrong

• Being the flow. Everybody rebalances on the same date, and a fund that trades naively at the close pays for the whole market knowing it had to.
• Synthetic replication hides a counterparty. The return arrives by swap, and the swap is only as good as who wrote it.
• Lending revenue treated as free. It closes the tracking gap and it is collateralised risk, taken on behalf of holders who mostly do not know it is being taken.
• An index nobody examined. A narrow or concentrated benchmark hands the fund a concentration the buyer thought they had diversified away.

Concepts to master

• Tracking difference and tracking error are different questions — how far off, and how reliably off.
• An index is a rule, not a portfolio. Everything it does is published in a methodology document, which is the seat's real reading.
• Creation and redemption is the arbitrage that keeps an ETF near its net asset value, and it needs somebody willing to do it.
• Cheap is the product. In a business where the return is fixed by the index, every decision is about cost.