Full replication and bondprices

To create an indexed portfolio using full replication, all the stocks in the index are purchased according to the weighting scheme used in the index. But in volume 4 SS 23, the answer to EOC 7: differences between the bond prices used by the maanger and the index provider limit managers ability to replicte bond index.

could you help me understand how the bondprices wil limit replicating. If i only look at weighting? I’ve hit a wall, so I am very sure you guys are still able to think logically…

are you a) reading question properly? – asks for least likely…

b) reading the answer properly either? answer choice is B provided… and this says “Factor #2: a lack of available index data to position the portfolio”.

Hi CPK, thanks for your comment. I was reading it properly, but maybe my question was not formulated clearly.

I agree that available index data does not limit replictation. the answer to the EOC. So the other 2 choices will likely limit the manager. I am trying to understand why different bondprices would limit replication. If I by all the bonds in the same weighting as the index and my internal prices are different than the index provides. I still own the bonds. Do they imply that maybe the calculated returns could be different?

index is being used to compare against.

the index is not investable - it is a paper portfolio. Manager’s portfolio is real.

If the prices on the manager’s portfolio are different from that on the index, there are two sources where the portfolio would suffer.

  1. level of returns before fees would be different.
  2. now after including the fees - the tracking risk would be different.

but again - I am asking you - why do you think the question says Bond prices would be different. Question stem says “Least likely”. So Bond Prices between index and Portfolio are LEAST LIKELY a source of difference. However there would be an impact of fees - because of which manager’s portfolio would always underperform the index.

Thanks CPK. I understand now why it could limit the manager, as pointed you it out clearly.

Page 9 of Volume 4 shows the problems for a full-replication strategy . ( section 3.1. the paragraph that has bullet # 1).

Bond prices used by the index could differ from the prices used by the manager due to high costs and inefficiency.