Index tracker fund (also known as index funds, tracker funds, and index trackers) is defined as a collection of securities that resemble the composition of an index. The most special feature of index tracker fund is that it buys all or part of the components in an index to build portfolio and adjust its ingredients while shares are deleted or added into the index. Thus its aims at replicating the movement of an index and obtain the profit at average market level.
The index tracker fund is designed based on the efficient-market hypothesis. According to the efficient-market hypothesis, the price of a share reflects all the information about the market. Here, the ‘all’ means any information tangible or intangible around a share and its issuing company, the market, and total details about the atmosphere. Because all investors are seeking opportunities to beat the market by drilling out any possibly helpful information and then they trade on the exchange, which incorporates their knowledge about the inaccessible or unavailable information into the movement of the prices, the price will soon return to its proper position even if it doesn’t at some point. The judgement shows that, none of the investors can out-perform the market and win extra profits.
However, some people may hire a management team to operate the portfolio and indeed they win more profit then those who use the index tracking strategy. EMH’s statement has extended meaning that the extra profit won by active management will be equal to the fee paid because of the very management, including the trading costs caused by intensive transaction, salaries for the management team, or information costs.
The methods to build a index tracker fund can be categorized into three kinds, the replication, the sampling, and the hybrid.
The replication method contains at least two types, the full replication and partial replication. For full replication method build portfolio by replicating all the components and their weights in an index. Usually this method works well when the index is not complicated and contains only a few components. But when the index has a large number of components, say 1000, the partial replication method should be used. It just replicates those components with larger weights. Since only a part of the components of an index is replicated, the building is simplified.
The sampling method differs from the replication method in the way that it is not subject to the components in an index only. The sampling method builds portfolio by sampling the market. It buys both the stocks in an index and the stocks outside the index. The only guideline for building a portfolio using sampling method is to replicate any stock that can represents the market.
The hybrid method incorporates the active investing into the index tracker fund, also known as enhanced indexing. A part of the portfolio is managed actively by a team while the rest of it remains passively managed. This method seeks ways to beat the market while keep the possibilities of wining profit at market level. A typical variation of indexing method is to buy futures of the components in an index instead of the shares. Because the futures are designed to hedge the risks, buying futures instead of shares are easier in management while keeping the ability of tracking the risk in the market.
In conclusion, index tracker fund is a safe way for investment. It avoids the non-systematic risks and wins profits at market level. And its variation can serve as alternatives for investment to beat the market.