Tracking Error and Replication Methods in Equity Investing

Very Hard Passive Equity Investing Replication Methods

ABC Asset Management is evaluating different replication methods for their equity portfolio aimed at tracking the S&P 500 index. They are particularly interested in minimizing tracking error while also considering transaction costs associated with the replication strategy. Three potential strategies have been identified:

1. Full replication, where the fund holds all 500 stocks in the S&P 500 in the same proportions as the index.

2. Sampling replication, where the fund holds a representative sample of stocks from the S&P 500, while aiming to capture the risk and return characteristics of the index.

3. Synthetic replication, utilizing derivatives such as futures or swaps to replicate the exposure of the S&P 500 without directly holding the underlying equities.

Given these options, which replication method is most likely to provide the lowest tracking error relative to the S&P 500 index?

Full replication, which provides precise tracking of the index.

Sampling replication, which aims to reduce transaction costs.

Synthetic replication, which may introduce additional basis risk.

Hint

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