Constructing a Passive Equity Index Fund

As a portfolio manager for a large institutional investor, you are tasked with constructing a new equity index fund that aims to reflect the performance of the U.S. equity market while maintaining a low tracking error and operational efficiency. You must decide on the appropriate methodology for index construction, including the selection criteria for stocks, weighting methodology, and rebalancing strategy.

Consider the following factors when providing your response: the implications of using market capitalization versus an alternative weighting scheme (e.g., equal weighting), the frequency of rebalancing, the selection process for including or excluding stocks, and the potential challenges associated with liquidity and market impact. Additionally, address how these choices align with the principles of passive investing, particularly in terms of minimizing costs and maximizing diversification.

Critically evaluate your proposed index construction strategy, justifying your decisions and addressing the trade-offs involved.