your question isn't clear

Emlyn,

Your query is kinda hazy but let me see if I can be of help...

When an investor builds up their portfolio based on a certain benchmark (such as NASI), there will be minimal tracking risk - as the performance of the portfolio is expected to track the performance of the benchmark.

When an investor has certain expectations or needs based on their experiences (what you are referring to as heuristic judgements), they could design their portfolio based on what their knowledge/experience.

That could increase the tracking risk if there are significant deviations between what the portfolio holds and the benchmark contains.

So, its really about handling the investor's heuristic judgments so as to minimise tracking risk.

Hope this helps.

Regards

Kamae Gai wa matuiní....come srowry.

Hi Emlyn,

When an investor decides to invest in either an index fund (or buy the shares in the index), they do so in the belief that the market is already effecient. Hence, there will be no need for one to deviate from the index weightings to gain additional return (alpha).

The success of such an investor would therefore be how closely related their return is related to the index return. Another success factor is their tracking risk - and if you combine the two is the active ratio.

As regards balancing, you would rarely expect the investor to rebalance their portfolio. One reason is that there are few instances where when a share is being added,replaced or deleted from the index.

Assuming that you have the NSE 20 as your benchamrk index, you would have decided to replace CMC Holdings by Uchumi Supermarkets today. NSE decided to make that change yesterday - on 8 December 2011 (See the media centre section on the NSE website).

The other instance would be incase of a corporate action such as exercing a rights issue - only if the action would not materially affect the weighting of that share in the index.

FYI, the index would automatically adjust for other corporate actions like a bonus share issue or stock split.

Hope this helps.

Regards

Emlyn,

It is true that such automatic adjustments could necessitate rebalancing.

But what I have seen over time is that an investor would initially decide to set a tolerance limit for any share in the index.

For instance, if the percentage holding for Uchumi within the index is 2.5%, then an investor may allow the holding to vary between 2% and 3% of the portfolio.

That way, one avoid many instances of rebalancing of the index thereby reducing transaction costs and net returns.

Regards