Equity Investment Style Classification

Which of the following portfolio construction processes _most likely_ meets BlueBank’s expectations?

Yes! Optimization is a mathematical approach to fund construction using a multifactor risk model and an objective function that specifies that securities be held in proportions that minimize expected tracking risk relative to the index. Optimization allows for index characteristics to be matched with a portfolio of a smaller number of stocks. And optimization considers the covariances among the factors used to explain the returns. And as such, optimization both reduces transaction costs and gives strong consideration to modern portfolio theory.

Incorrect. Full replication involves purchasing all stocks present in an index, resulting in higher transaction costs relative to those of other portfolio construction methods.

Incorrect. Stratified sampling involves breaking the index into categories and using a random sample of stocks from each category to ensure the sum of the weights of the stocks purchased from each category corresponds to the category’s weight in the index. While this method reduces transaction costs relative to full replication, it doesn't implicitly give strong consideration to modern portfolio theory.

Optimization

Full replication

Stratified sampling