Opportunity is knocking on investors’ doors in the form of exchange traded funds (ETFs). They are becoming increasingly popular with both investors and advisors and they’re bringing more technique and innovation to the table than ever before.

Now investors can access a wide range of markets across the world, as well as tap into currencies and commodities and more, and be diversified by just owning a few funds. The key word is "simplicity."

Stephen Spurden for Telegraph UK reports on the different ways indexes are constructed when it comes to ETFs:

  • Full Replication: A basket of shares directly mirroring the underlying index.
  • Strategic Sampling: A basket of shares reflecting the major stocks in the underlying index, and a representative sampling of shares in each sector; uses derivatives such as futures, too.
  • Synthetic Replication: Uses 90% of the index plus cash held in the portfolio exchanged as collateral as a derivative instrument called a "swap" that copies the exact movement of the full underlying index.

Knowing the method by which your ETF is constructed is important, especially if you’re buying the fund because of a particular holding. You want to be sure the holding is there, after all. It’s just another argument in favor of doing your homework and knowing what you own.

For a further explanation of index optimization vs. replication, visit our post where we discuss the pros and cons of each.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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