Canadian Securities Course (CSC) Level 2 Practice Exam

Which sampling method is associated with increased tracking error in ETFs?

1. Selection bias

2. Random sampling

3. Systematic sampling

4. Weighted sampling

The correct answer is: Systematic sampling

In the context of Exchange-Traded Funds (ETFs), systematic sampling is associated with increased tracking error due to its approach of selecting a subset of the underlying securities based on certain criteria rather than attempting to precisely replicate the entire portfolio. This methodology can lead to a mismatch between the ETF's performance and that of the benchmark index it aims to track, resulting in tracking error. Systematic sampling may involve selecting securities based on factors such as market capitalization, sector, or other quantitative measures, which can limit the number of securities held by the ETF. If the selected securities do not perform similarly to the full benchmark, it can create deviations in performance, hence the increased tracking error. In contrast, other sampling methods like random sampling tend to produce a portfolio that more closely represents the overall index, thereby typically resulting in lower tracking error. Weighted sampling, on the other hand, aims to maintain similar proportions to the index, further minimizing discrepancies in performance. Selection bias, while an important consideration, does not directly refer to a particular sampling method's structure concerning tracking error in ETFs.