Questions about Sampling Strategy ETFs (index funds)

Question

1) If I understand correctly, a Sampling Strategy ETF is an index fund in which:

• 100% of assets are allocated in <100% of the companies composing the index.

• <100% of assets are allocated in <100% of the companies composing the index and the rest of the assets are allocated in different areas.

If my understanding correct?

2)

One example is the iShares Russell 2000 ETF (IWM B+). IWM invests 90% of its assets in stocks from the underlying index. Its remaining assets are invested in products such as futures, options and swap contracts, as well as securities not included in the underlying index. This is done because the fund manager feels these instruments will create a more efficient replica of the original than trying to purchase every stock in the index. Rather than buying all 2,000 stocks that compose the Russell, and then have to exactly match the weightings of each security, the fund manager uses approximately 10% of assets to replicate the index with derivatives.

I do not understand how "these instruments will create a more efficient replica of the original than trying to purchase every stock in the index." Do they mean that investing in every single company will prove too complicated since some are not listed on big exchanges? And when talking about replicating "the index with derivatives" do they mean the growth rate in "the index with derivatives" would be the same as in the real index? How does the fund manager choose these other investments that will "replicate the index" ?

Answer 1

1) Yes.

2) So all index ETFs attempt to replicate an index but some indices are easier than others to replicate. While most of the stocks included in the index are likely on exchanges, some of the small-cap stocks can be thinly traded and have high trading costs. Therefore a full replication of the index could be rather expensive as when the index changes month to month the costs from buying and selling all these small stocks adds up. This is what Russell is trying to fix when they talk about efficiency.

What Russell does instead is replicate the return stream (day-to-day returns) of the index as best they can while at the same time minimizing the cost. They generally start by buying all the stocks that are cheap to trade in the amount that the index specifies. Then they look at the remaining thinly traded stocks both individually and in groups and attempt to find stocks that have similar characteristics and similar return streams but are cheaper to trade. Finally they employ derivatives to "true up" their replication portfolio return stream to the index return stream and to track the hardest to replicate stocks. The result can replicate rather well if they do a good job but there will likely be some differences.

There are some more steps but that is a broad outline of how it works. Note the last sentence in the quote you is confusingly written it might be more understandable as "... the fund manager deploys approximately 10% of assets in derivatives to help replicate the index."

EDIT (in response to questions):

The ETF does invest directly in the company through their stock. However, when buying/selling stock there are some costs involved that you can think of as (more or less) paying a broker to find someone that wants to sell when you want to buy. Those costs can be significantly higher for small, lightly traded companies.

The details of how these ETFs work are usually proprietary but in this case I can guess. If you look at the detailed holdings of IWM (Portfolio tab) all the way near the bottom you can see they hold only a single derivative Russell 2000 Futures (RTYH8). Think of this as being lazy, the futures contract in this case is just an agreement that the ETF custodians pay another party and that party gives them the returns of the Russell 2000 index in the next couple months. It's like pawning the problem to someone else. These futures contracts are relatively expensive, so that is why they use only a small amount (way less than the 10% max they could possibly deploy). Still, they are cheaper than trading the most expensive of the stocks in the index.