Replication Methods in Passive Equity Investing

As a portfolio manager at an investment firm, you are tasked with implementing a passive equity investment strategy aimed at tracking the performance of a benchmark index. Your firm has decided to employ replication methods to ensure that the portfolio closely aligns with the characteristics of the index.

Discuss the various replication methods used in passive equity investing, such as full replication and stratified sampling. In your essay, provide detailed explanations of how each method operates, the advantages and disadvantages associated with them, and circumstances under which one method may be more beneficial than the other. Additionally, illustrate the implications of transaction costs, liquidity constraints, and tracking error when choosing a replication method.

Finally, reflect on how market conditions might influence the choice of a replication strategy and provide a specific example of a scenario where a particular method would be favored over another.