FRM Part II · FRM Exam Part II · Portfolio Construction

A fund uses a risk-budgeted portfolio with a 1% daily turnover cap and trades illiquid assets whose transaction costs rise more than proportionally with trade size. A manager rebalances fully back to optimal weights each day whenever the weights drift. Which change best improves net performance consistent with practical implementation?

The best change is a no-trade band with partial trading toward target weights. Because costs rise more than proportionally with trade size, spreading trades and tolerating limited drift balances tracking error against market impact, improving net returns versus full daily rebalancing or never rebalancing.

1. AIntroduce a no-trade region around target weights and trade only partially toward the optimum, so costs are balanced against tracking errorCorrect
2. BRebalance only at year-end regardless of drift to eliminate all costs
3. CAssume linear transaction costs so that large trades are executed in a single block
4. DIgnore market impact, since it affects only gross returns and not net returns