Disadvantages of Stratified Sampling Approach to Equity Portfolio Mgmt costs, books, index, factors, between

jbaldyga

The books don't seem to elaborate to much on the disadvantages of this approach. From what I can gather its:

>Increased trading costs over full replication approach to align portfolio with characteristics of index
>Implicitely assumes that the covariances between risk factors are uncorrelated

Any other thougths?

Iginla2011

not sure on point 2 off the top of my head, but is that first disadvantage correct?

i thought full replication has high trading costs, but the stratified sampling approach allows for lower costs (you can use sampling to achieve virtually identical exposures without needing to purchase every stock in the index?)

dyga

Index is assumed to be relatively stable ( modern indices are based on Cap weighting , so their composition hardly vary over long periods).

When you use stratified sampling , you are subject to more tracking error (if individual positions move much more than the index) and so you have to continuously trade to get back to sector weight limits or max individual weight limits . Hence trading costs could increase.

Remember, a passive index fund holds diversified positions ( probably built over long period of time ) but hardly trades in or out