Full replication

Holding every index constituent at its index weight. It keeps tracking error low, but becomes costly for indexes with many small or illiquid holdings, where sampling or optimisation is used instead.

Where you will meet it

Full replication appears in 4 learning outcomes on the CFA syllabus. A few of them:

• Set out where ETF tracking error comes from
  CFA Level II · Portfolio Construction

  “Sources include fund expenses, which make returns lag the index, and representative sampling instead of full replication.”

• Weigh full replication against stratified sampling and optimisation as ways to build an index-tracking equity portfolio
  CFA Level III · Portfolio Management Pathway

  “Full replication holds every constituent at its index weight; it gives the lowest tracking error and suits indexes with a modest number of liquid stocks, but costs rise when there are many small or illiquid names.”

• Explain why an index portfolio can drift from its benchmark and how that tracking error is kept in check
  CFA Level III · Portfolio Management Pathway

  “Sources include fees and commissions, cash drag from dividends and inflows not yet invested, index reconstitutions and corporate actions that force trades, sampling or optimisation that falls short of full replication, and market impact when trading illiquid names.”

• Contrast the ways an investor can take on passive exposure to bond markets
  CFA Level III · Portfolio Management Pathway

  “Full replication buys every bond in the index; it is rarely feasible given index size and illiquidity.”

See also

Active risk

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
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