Index Construction and Tracking Error

In the context of passive equity investing, the construction of an index can significantly impact the performance and risk profile of an investment portfolio. Consider the following scenario:

A large institutional investor is evaluating three different methodologies for constructing an equity index. The investor is particularly interested in minimizing tracking error relative to the benchmark index while ensuring that the selected methodology reflects the overall market exposure effectively. The three methodologies under consideration are:

1. Market Capitalization Weighted Index
2. Equal Weight Index
3. Fundamentally Weighted Index

The investor aims to understand how each methodology will perform in terms of tracking error, liquidity, and overall market representation.