CFA Level III · Portfolio Management Pathway

Index-Based Equity Strategies for CFA Level 3

Index-based equity strategies aim to match the return of a benchmark index at low cost instead of beating it. You solve questions by linking the client's objectives and constraints to the index choice, weighting scheme, construction method, vehicle and the tracking error you can accept.

What this chapter covers

This chapter covers how portfolios are built to follow an equity index rather than beat it. You start with the case for passive versus active investing. Then you study how indexes are built and weighted, how a manager copies an index, how tracking error is measured and controlled, which vehicles deliver index exposure, and how enhanced indexing and securities lending try to add a little return.

The chapter is mostly about trade-offs. Full replication gives the lowest tracking error but costs more in trading and holds illiquid names. Sampling and optimization cut costs but add tracking risk. Each vehicle has its own costs, taxes, liquidity and counterparty issues. Expect to compare options and pick one.

It connects to the rest of the paper through the client. Index strategies sit inside the equity portfolio construction decisions in the core topics, and they link to derivatives (futures and swaps), performance measurement (tracking error, active share) and the Ethics topic when fees and lending practices are disclosed. In item sets and essays, you will usually be asked to justify a choice for a specific client.

This chapter is a good place to collect points because the ideas are concrete and repeat across questions. You may get a calculation on tracking error or a weighting comparison, or a short justification asking which method or vehicle suits a client and why. Candidates who know the trade-offs and write them in a few precise words earn full credit on 12-point sets. The chapter also supports other topics, such as portfolio construction and derivatives, so the effort pays back elsewhere.

Index-Based Equity Strategies: topics in the order to study them

1Passive vs Active Equity InvestingIt gives the reasoning for indexing and the vocabulary (active share, costs, benchmark) used in every later topic.
2Equity Indexes and Weighting SchemesYou need to know what is being copied, and how each weighting scheme changes exposures and turnover, before you learn how to copy it.
3Indexing Methods: Full Replication, Sampling, OptimizationOnce you know the index, you learn the ways to build a portfolio that follows it and the trade-offs of each.
4Tracking Error and Index Fund ManagementIt measures how well the construction method works and explains the sources of difference between fund and index.
5Index-Based Vehicles: ETFs, Futures, Swaps, Mutual FundsWith the method and tracking concepts clear, you can compare the wrappers that deliver the exposure.
6Enhanced Indexing and Index Securities LendingThese build on indexing by accepting small, controlled deviations or extra income, so they come last.

How to prepare Index-Based Equity Strategies

Aim to explain each choice in terms of cost, tracking risk and client needs. Practise writing short answers, not just reading.

Read the first two topics in one sitting and write a one-page comparison of passive and active, and of each weighting scheme, covering what it overweights and its turnover.
Make a table of replication, sampling and optimization: when each suits, cost, tracking error, and the index types where it is used.
Learn the tracking error definition and the sources of tracking difference, then practise the calculations by writing out every step to check your work.
Build a vehicle comparison for ETFs, futures, swaps and mutual funds: cost, liquidity, taxes, counterparty risk, and what each is best for.
Study enhanced indexing and securities lending as controlled departures from the index, noting the added return source and the added risk.
Do item sets and essays on the chapter. For essays, answer the command word exactly, give only the number of responses asked for, and tie each reason to the client.
Review wrong answers in a log and re-test them after a few days.

Common mistakes in Index-Based Equity Strategies

Choosing a method or vehicle without referring to the client's objectives and constraints.
Fix: Start each answer from the client's goal, liquidity, tax and risk limits, then link one feature to each.
Saying full replication is always best.
Fix: Remember the costs and illiquid holdings in large or broad indexes, where sampling or optimization may suit better.
Mixing up tracking error and tracking difference.
Fix: Tracking difference is the return gap; tracking error is the standard deviation of that gap over time.
Giving more responses than the question asks for.
Fix: Give exactly the number requested, in the order requested, because only those are evaluated.
Ignoring the risks of lending and derivatives-based exposure.
Fix: Pair every benefit with its risk: counterparty, collateral, roll cost, margin and governance.
Typing a wrong or unclear final number in tracking error questions.
Fix: Write the active returns and formula steps on scratch paper to check your work, then type the final number clearly. A correct number typed on its own earns full credit, so do not count on credit for steps.

Last-day revision: Index-Based Equity Strategies

Passive aims to match the index at low cost; active aims to beat it and carries higher fees and manager risk.
Market-cap weighting follows the market, has low turnover, and can overweight overvalued stocks.
Equal weighting tilts to smaller companies and needs more rebalancing, so it has higher turnover.
Fundamental and other alternative weightings add rules and potential factor tilts that differ from the market.
Full replication holds every index security and gives the lowest tracking error, but costs more for large or illiquid indexes.
Sampling and optimization hold a subset to cut costs, at the price of more tracking error.
Tracking error is the standard deviation of the active return, the difference between portfolio and index returns.
Fund costs, cash drag, rebalancing and index changes cause tracking difference.
Futures and swaps give index exposure with little cash but bring roll, margin or counterparty considerations.
ETFs trade intraday and are often tax efficient; check spreads and premiums or discounts to NAV.
Enhanced indexing seeks a small excess return with tightly limited tracking risk.
Securities lending adds income but brings counterparty and collateral risk, and needs governance.

Index-Based Equity Strategies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Index-Based Equity Strategies: frequently asked questions

How should I split study time within this chapter?

Spend the most time on construction methods, tracking error and vehicle comparison, because they produce calculations and justifications. Passive versus active and weighting schemes need less time but must be accurate. Keep a short block for enhanced indexing and lending.

Do I need to memorise formulas for index funds?

You need the tracking error idea and how to compute it from active returns. Work through the steps to check your answer, because a correct number typed on its own earns full credit. Most other content is conceptual, so practise explaining trade-offs in short sentences.

How does this chapter link to derivatives?

Futures and swaps are index-exposure vehicles, so you apply derivatives knowledge to cost, margin, roll and counterparty risk. Revisit those points in the derivatives topic after you finish here.

How do I write a good essay answer on index strategies?

Follow the command word, such as justify or compare, and answer only what is asked. Give the choice, then one or two reasons tied to the client. For any calculation, a correct number typed on its own earns full credit, so make sure the number is right.