It may be tempting to skimp on due diligence for index funds and exchange-traded funds. After all, they typically employ transparent, rules-based strategies that are not susceptible to key-manager risk. But seemingly similar index funds can look and perform differently, so portfolio construction still matters. To evaluate these funds’ processes, we set out to answer two questions: 1) How is the index constructed? and 2) How is the portfolio managed to deliver high-fidelity tracking performance of its index? The former determines the composition of the portfolio and how the fund will behave. The latter focuses on both the fund’s replication strategy and structure. While it is important, it doesn’t move the needle as much as index construction, which is the focus of this article.
Index Construction Framework
The best index funds have portfolios that are representative of their actively managed peers—or in the case of strategic-beta funds, the style they are trying to capture. They are well-diversified, investable, transparent, sensible, and take steps to mitigate unnecessary turnover. Looking at these dimensions can help us differentiate between seemingly similar strategies and better evaluate their merit.
