Benchmark Tracking Hierarchy

CFA Level III Equities
#1

Can someone help me contribute a cost hierarchy to replicating an index?

Would it be (highest to lowest)

  1. Full Replication

  2. Optimization

  3. Stratified Sampling

  4. Mutual Fund

  5. ETF

#2

Cost is a bit relative with benchmarks…heres a few poitns though:

  1. In general, ETFs are lower cost than Mutual Funds, except for licensing fees. That said, it is safe to assume that they are cheaper. They are also more tax efficient.

  2. Full replication is best when there are less than 1000 holdings and the holdings are liquid. Once you get more holdings, the cost of buying all the securities gets too high.

  3. Optimization optimizes to match primary risk factors, and may be cheapr from a money standpoint to construct. It could be ecomplex and more expensive from a time cost compared to a Full Replication. More importantly, it will have to be rebalanced much more often, and therefore costs going forward for rebalancing will be higher than both stratified sampling and full replication.

  4. Stratefied sampling is good when you cant use Full replication and want to minimize rebalancing costs. However, it will tend to have higher tracking error than both the optimization and full replication methods.

I dont think you need to compare Index mutual funds and etfs to these forms of constructing an index, Its not really a relevant comparison.

#3

They all do not fall under the same umbrella.

Full Replication > Optimization > Stratified Sampling is 1 way … on the indexing strategies themselves.

And Mutual Fund (lower license fees, but higher everything else) > ETF (more tax efficient, no shareholder level expensing, trades throughout the day, Long term more efficient, for derivatives transaction an ETF Futures has more saving than a Indexed MF Futures contract).

I split these up because you could have an indexed MF with Full Repl., Stratified Sampling or Optimization techniques used.

#4

Nice reply +1. ETFs and Mutual Funds do not fall into the same category as the types of index replication.

#5

I realize they are different, but I am basing this off of the question 17 in reading 27, page 281, asking which method has the highest cost in meeting the goal of minimizing tracking error.

So while, yes they are different, we may be presented with a cost question. So I repeat, is the cost hierarchy

  1. Full Replication

  2. Optimization

  3. Stratified Sampling

  4. Mutual Fund

  5. ETF

CP?, Anyone?

#6

Least tracking error = Full Replication of Index

Highest investment cost = Full Replication of Index.

I answered above in more generic terms.

FR > O > SS

MF > ETF

FR,O, SS can be combined with the other methods … so

#7

I realize they can be combined, but like i said…the CFAI question was which is highest , full replication, Mutual Fund, ETF…

So if we have to disregard the mixing of the types and have to compare them, the order is Full repl, MF, ETF.