A Tale of Two Index Funds: Full Replication vs. Representative Sampling

Abstract

We examine the two approaches used by equity index funds to track their benchmark index. The first, full replication, mimics the index with exactness. The second, representative sampling, holds a subset of the index. We find that samplers trade 3-4 times more, have 30-50% higher expenses and fees, and earn 50-70 basis points lower annual returns, which is substantial given index funds’ mandate to limit tracking error to a few basis points. Besides higher expenses and transaction costs, poor stock picking also seems to contribute to samplers’ return underperformance. Overall, our analyses suggest representative sampling is associated with underperformance.

Keywords: passive investing, index funds, full replication, representative sampling, fund performance, returns, portfolio turnover, expense ratio, management fees, stock picking

JEL Classification: D02, D14, G11, G23, G51, G53, J32