Reading 31: Equity Portfolio Management－LOS f recommend, investment, contrast

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CFA Institute Area 8-11, 13: Asset Valuation
Session 10: Equity Portfolio Management
Reading 31: Equity Portfolio Management
LOS f: Compare and contrast full replication, stratified sampling, and optimization as approaches to constructing an indexed portfolio and recommend an approach when given a description of the investment vehicle and the index to be tracked.

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An investor would like to track an index. Compared to stratified sampling and optimization, when would replication be favored? When the index has:

A) more than 1,000 stocks and liquid stocks.

B) less than 1,000 stocks and liquid stocks.

C) less than 1,000 stocks and illiquid stocks.

D) more than 1,000 stocks and illiquid stocks.

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Answer and Explanation

Full replication is more likely to be used when the number of stocks in the index is less than 1,000 and when the stocks in the index are liquid.

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An investor would like to track an index and is considering using optimization. Optimization is characterized by:

A) the use of a factor model and infrequent rebalancing.

B) the use of a factor model and frequent rebalancing.

C) the use of a matrix model and frequent rebalancing.

D) the use of a matrix model and infrequent rebalancing.

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Answer and Explanation

An optimization approach uses a factor model to match the factor exposures of the fund and the index. Optimization must be updated to reflect changes in risk sensitivities from the factor model and this leads to frequent rebalancing.

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An investor would like to track an index. Compared to optimization, stratified sampling:

A) assumes the covariances are zero and leads to lower tracking risk.

B) assumes the covariances are zero and leads to higher tracking risk.

C) models the covariances and leads to higher tracking risk.

D) models the covariances and leads to lower tracking risk.

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Answer and Explanation

In a stratified sampling procedure, it is implicitly assumed that the risk factors have a covariance of zero. An optimization approach accounts for the covariances between the risk factors. An optimization approach leads to lower tracking risk than a stratified sampling approach.

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An investor would like to track an index. Comparing optimization, stratified sampling, and replication; in which of the following indexes would the investor be least likely to use replication?

A) A value-weighted index.

B) A free float-adjusted market capitalization index.

C) A price-weighted index.

D) An equal-weighted index.

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Answer and Explanation

An equal-weighted index usually has a large representation in small-cap stocks. Replication would involve purchasing all the stocks in the index and this would be less feasible when there are small-cap stocks involved. The reason is that small-cap stocks tend to have lower liquidity and higher trading costs