Sample Questions
Question 1
Easy
Cash drag in an index fund refers to the performance impact of:
Solution
A is correct.
Cash drag occurs when an index fund holds uninvested cash from received dividends, new investor subscriptions, or pending corporate actions. Because the index assumes full investment at all times, the fund's cash position creates a return difference. In rising markets, cash drag causes underperformance; in declining markets, it can provide a small buffer.
Cash drag occurs when an index fund holds uninvested cash from received dividends, new investor subscriptions, or pending corporate actions. Because the index assumes full investment at all times, the fund's cash position creates a return difference. In rising markets, cash drag causes underperformance; in declining markets, it can provide a small buffer.
Question 2
Medium
Compared to market-cap-weighted indices, factor-based indices typically have:
Solution
B is correct.
Factor-based indices require periodic reconstitution to update factor scores and rebalance to target weights. As stocks' factor characteristics change (e.g., a value stock becomes fairly valued, a momentum stock reverses), the index must add and remove constituents, generating higher turnover than a market-cap-weighted index, which is largely self-rebalancing (prices adjust weights automatically).
Factor-based indices require periodic reconstitution to update factor scores and rebalance to target weights. As stocks' factor characteristics change (e.g., a value stock becomes fairly valued, a momentum stock reverses), the index must add and remove constituents, generating higher turnover than a market-cap-weighted index, which is largely self-rebalancing (prices adjust weights automatically).
Question 3
Hard
Based on Exhibit 1, if Sharma implements the entire $420 million US large-cap allocation using full replication rather than optimization, the additional expected annual transaction cost is closest to:
Solution
A is correct. Exhibit 1 gives expected annual transaction costs of 8 bps for full replication and 4 bps for optimization, so the incremental cost of full replication is bps. Applied to the allocation, The trade-off is that full replication is expected to cut tracking error from 15 bps to 5 bps, a 10 bps improvement in benchmark-relative risk purchased with roughly of additional annual trading and rebalancing cost. Transaction costs incurred to keep holdings aligned with index changes are a recurring source of return drag for an index-based portfolio, and they rise with the number of names held and the frequency of index reconstitution.
