The most intuitive means of creating an index portfolio is to fully replicate the index by buying shares of each company in the index according to its relative weight in the index. Full replication works best when the index contains relatively few companies and those companies’ shares are relatively liquid.
Advantages of Full Replication:
- Little tracking risk relative to the index
- When the portfolio is based on a value-weighted index, it will be self-rebalancing
A fully replicated index portfolio should have return characteristics that closely match those of the underlying index. However, returns could be lower by an amount equal to the sum of:
- The management and administrative costs of the fund
- Transaction costs related to changes in index composition
- Transaction costs related to investing and disinvesting cash flows
- Performance drags related to having cash positions when markets are advancing
If the index contains a large number of illiquid stocks, full replication will usually underperform the index because the portfolio will have to bear transaction costs that the index does not.
Source: Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)