What is portfolio replication?

Capturing true portfolio returns

While the concept of Portfolio replication has been around for some time, it has been shrouded and cloaked in mystery.  Terminology like algorithm, static and dynamic replication, stochastic modeling, linear regression, and tracking error cause most eyes to glaze.
 
The Farlex Financial Dictionary defines and demystifies the definition of Portfolio Replication.  “A portfolio that attempts to match, as closely as possible, some benchmark or index.”  By using this simple but elegant definition, we can now see how the S & P 500 is a “portfolio” that attempts to match a certain “benchmark”.  (The United States Stock Market).   The concept need not be any more complicated. 
 
And while the S & P index was introduced in 1923, (the index in its current form was introduced in 1957), modern computing and technology has given us the ability to replicate or “clone” virtually any mutual fund offering.  Closely cloning alpha and beta characteristics, while maintaining a low tracking error, has allowed investment professionals to reduce investment costs and expand the concept of “Solutions Based Investment Consulting”.
 
Armed with Portfolio Replication, consultants can now offer low cost alternatives to popular mutual fund offerings with more transparency and better risk control.  Custom Indices of mutual funds can be constructed at much lower costs and open the possibility of utilizing additional yield, growth, and risk features.  In addition to the simple “fee arbitrage” benefit, portfolio replication can also be used to solve more complex problems including, SRI/ESG needs, asset based revenue hedging, Variable Annuity basis risk hedging, and investment platform risk exposure hedging.
 
Get to know the concept of Portfolio Replication.  It’s coming, and it’s going to be here for some time to come.