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. Samplers’ underperformance is not purely driven by higher expenses and transaction costs, but also poor stock picking. Overall, our analyses suggest representative sampling is detrimental to index investors.

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