Figure 82 Russell Index Security Selection

problem by sampling stocks in the index. By sampling an index, an ETF manager selects liquid securities representing various industries in an attempt to replicate the movement of an index without owning all stocks in that index. Managers who use a sampling technique also tend to employ a sophisticated portfolio optimization process that helps reduce the funds' tracking error with an index. An ETF that uses sampling is still considered to have passive security selection. The intent is to replicate that index as closely as possible.

The iShares Russell Micro Cap ETF (symbol: IWC) is bench-marked to the passively selected Russell Micro Cap index. It cannot be fully replicated in an actual portfolio because many of the smallest 1,000 stocks in the index do not have enough liquidity. Although the Russell Micro Cap index has 2,000 stocks, IWC is composed of only about 1,200 liquid stocks sampled from the index.

Some ETFs follow baskets of securities that are selected once and never changed. An example of ETFs using a buy-and-hold strategy is Holding Company Depositary Receipts (HOLDRs). Stocks in HOL-DRs are selected once on the basis of a passive method. Then the basket becomes an unmanaged trust (see Chapter 3 for details). The advantage of this method is its extremely low cost (there is no management fee). The disadvantage is that no new securities can go into a fund. Once the stocks are selected at inception, they become a fixed buy-and-hold basket. Stock can be taken out of the basket because of mergers and acquisitions, but no new companies can replace them.

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