Weigh full replication against stratified sampling and optimisation as ways to build an index-tracking equity portfolio
The idea
Full replication holds every constituent at its index weight; it gives the lowest tracking error and suits indexes with a modest number of liquid stocks, but costs rise when there are many small or illiquid names. Stratified sampling divides the index into cells, for example sector by size, and holds a sample of stocks in each cell so that cell weights match the index; it suits broad indexes and smaller portfolios. Optimisation uses a factor risk model to choose holdings that minimise expected tracking error; it copes with large universes but relies on historical covariances and needs regular re-optimisation. The trap is assuming replication is always best; with many illiquid constituents its trading costs can outweigh sampling error.
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- Contrast factor-tilted index strategies with plain market-cap-weighted indexing
- Contrast the alternative ways of designing an index-based equity strategy
- Contrast the vehicles through which an investor can gain index-based equity exposure
- Explain why an index portfolio can drift from its benchmark and how that tracking error is kept in check
- Identify where the returns and the risks of an index-tracking equity portfolio come from