IBBC CAPITAL ACADEMY / 2027
Index portfolios: choose the exposure before the vehicle
Independent IBBC Capital draft content for self-study. Not affiliated with or endorsed by CFA Institute. New lessons await subject-matter review. No CFA designation or official PSM credit is awarded.
Learning goals
- Diagnose the case using the stated constraints and quantitative evidence.
- Defend a conditional decision and identify what further evidence could reverse it.
Draft · approximately 65 minutes, excluding further revision.
Decision case · fictional facts
A pension allocates 100 m to a broad equity index. Fund A charges 0.10% and tracks at 0.08% annualized volatility of active returns; factor fund B charges 0.30% and has 4% active risk versus the broad index. Daily liquidity and low operational complexity are required.
Separate index design from implementation
Capitalization weighting reflects market values; factor weighting deliberately tilts exposures and can create concentration, turnover and long periods of underperformance against a broad market. Both can follow explicit rules. Calling a factor strategy passive does not remove its active economic bets relative to the client’s chosen benchmark.
Replication, sampling and vehicles
Full replication holds constituents; sampling approximates exposures with fewer holdings; optimization minimizes a modeled discrepancy subject to costs and constraints. Funds, ETFs, separate accounts and derivatives provide different custody, cash, counterparty and trading arrangements. Illiquid constituents and index changes can make literal replication expensive.
Diagnose tracking, not just fee
Tracking difference is portfolio return minus benchmark return; tracking error is variability of active return. Fees, cash drag, tax, index reconstitution, sampling and securities lending affect realized results. Review benchmark total-return conventions, dividend treatment and implementation timing. Lower fee alone does not guarantee better tracking.
Formula and assumptions
Fee=AUM×rate; active return=portfolio−benchmark; tracking error=SD(active return)
Compare with the model response after drafting
- A costs 100,000 annually on 100 m; B costs 300,000. The 200,000 gap matters, but the 4% active-risk difference reflects a different exposure mandate.
- Choose a broad-index vehicle consistent with the mandate; test spreads, cash handling and sampling risk before selection. Do not substitute a factor mandate solely for a return story.
Errors to catch
- Equating rules-based with zero active risk.
Write, compare, then self-assess
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Original knowledge check
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Sources and coverage status
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